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Business economics: A contemporary approach
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Business economics: A contemporary approach Peter Earl & Tim Wakeley
London Boston Burr Ridge, IL Dubuque, IA Madison, WI New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto
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Business Economics: A Contemporary Approach Peter Earl & Tim Wakeley ISBN 0-07-7103920
Published by McGraw-Hill Education Shoppenhangers Road Maidenhead Berkshire SL6 2QL Telephone: 44 (0) 1628 502 500 Fax: 44 (0) 1628 770 224 Website: www.mcgraw-hill.co.uk British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data The Library of Congress data for this book has been applied for from the Library of Congress Acquisitions Editor: Kirsty Reade Development Editors: Emily Jefferson and Catriona Watson Marketing Director: Petra Skytte Senior Production Editor: Eleanor Hayes Text Design by Pantek Arts Ltd, Maidstone Kent Cover design by Ego Creative Ltd Printed and bound in Spain by Mateu Cromo Artes Graficas, Madrid Published by McGraw-Hill Education (UK) Limited an imprint of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY 10020. Copyright © 2005 by McGraw-Hill Education (UK) Limited. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. ISBN 0-07-7103920 © 2005. Exclusive rights by The McGraw-Hill Companies, Inc. for manufacture and export. This book cannot be re-exported from the country to which it is sold by McGraw-Hill.
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Dedication We would like to dedicate this book to the following scholars, or to their memory. They have inspired us to seek a deeper understanding of how the world really works. It is because of their efforts that contemporary economics is something more than an esoteric science. Philip Andrews Alfred Chandler Richard Cyert Jack Downie Neil Kay Richard Langlois Brian Loasby James March Alfred Marshall Richard Nelson Edith Penrose Jason Potts George Richardson Joseph Schumpeter George Shackle Herbert Simon Sidney Winter
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Brief Table of Contents
1 Introduction 1 2 Markets and models 19 3 What do entrepreneurs do? 61 4 Who wants the product and in what quantity? 91 5 How shall the firm produce the product? 139 6 Where do costs come from and how do they behave? 181 7 How can the firm set the ‘right’ price? 219 8 How can the firm earn persistent above-normal profits? 265 9 A business enterprise is born 291 10 How can the firm grow? 341 11 What can an established firm do when its sales volume stagnates
or declines? 387 12 Fundamentals of macroeconomics 417 13 What are the main sources of controversy in macroeconomics? 461 14 The international environment 507
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Preface xiii Acknowledgements xxi Guided tour xxii Technology to enhance learning and teaching xxiv 1 Introduction 1 1.1 Introduction 2 1.2 The economic problem 2 1.3 An example of the ‘economic way of thinking’ 4 1.4 Problems of information and imperfect knowledge faced by decision makers 7 1.4.1 Varieties of problems of information and knowledge 8 1.4.2 Factors that generate problems of information and knowledge 14 1.5 Summary 15 1.6 Some questions to consider 16 1.7 Recommended additional reading sources 16
2 Markets and models 19 2.1
Introduction 20
2.2
Specialization 22
2.3
Scope for failures in economic co-ordination 24
2.4
Market-based co-ordination via the price mechanism 26 2.4.1 The mainstream view of ‘a market’ 27 2.4.2 How markets work 27
2.5
A mainstream model of the hot dog market 30
2.6
Further discussion of the hot dog model 32
2.7
The art of applying a model 39
2.8
The mainstream view of economic systems 43
2.9
The heterodox view of economic systems and co-ordination 47
2.10 Markets as institutional structures 52 2.11 The firm as an answer to market failure 54 2.12 Summary 57 2.13 Some questions to consider 58 2.14 Recommended additional reading sources 59
3 What do entrepreneurs do? 61 3.1 Introduction 62 3.2 An entrepreneur’s story: the early years of Sir Richard Branson 62 3.3 Six perspectives on the economics of the entrepreneur 67 3.3.1 The mainstream perspective on the entrepreneur 68 3.3.2 The entrepreneur and the inefficient firm 69
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3.3.3 The Austrian perspective on the entrepreneur 70 3.3.4 Schumpeter on the entrepreneur as innovator 72 3.3.5 The entrepreneur as a specialist in co-ordination 74 3.3.6 Empirical analysis of the entrepreneur 80 3.3.7 A new departure – the entrepreneur as a constructor of connections 82
3.4 Summary 85 3.5 Some questions to consider 87 3.6 Recommended additional reading sources 88
4 Who wants the product and in what quantity? 91 4.1 4.2
Introduction 92 Mainstream consumer theory 95 4.2.1 Indifference analysis 96 4.2.2 Marginal utility theory 99 4.2.3 Demand for product characteristics 103
4.3 4.4
Contexts of choice 104 Behavioural/evolutionary consumer theory 112 4.4.1 The struggle against increasing entropy 112 4.4.2 Consumer preferences exist at several levels 113 4.4.3 Rules for closing open minds 116 4.4.4 We’re all hunter-gatherers, really 120
4.5
Fads, fashions and product lifecycles 121
4.6
Products in the context of lifestyles 125
4.7
Purchasing decisions of businesses 127
4.8
Brand loyalty and brand equity 130
4.9
Summary 132
4.10 Some questions to consider 134 4.11 Recommended additional reading sources 135
5 How shall the firm produce the product? 139 5.1 Introduction 140 5.2 The story of Dyson vacuum cleaners 140 5.3 The mainstream theory of production 147 5.3.1 Overview 147 5.3.2 The basic elements of the mainstream story 148 5.3.3 The short-run theory of production 150 5.3.4 The long-run theory of production 155
5.4 The heterodox approach to production 164 5.4.1 Overview 164 5.4.2 Knowledge 164 5.4.3 Returns to scale 168 5.5 Summary 176 5.6 Some questions to consider 179 5.7 Recommended additional reading sources
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6 Where do costs come from and how do they behave? 181 6.1 Introduction 182 6.2 The mainstream approach to the behaviour of costs 182 6.2.1 The short-run theory of costs 182 6.2.2 The long-run theory of costs 189 6.2.3 Economies of scale – further discussion 196 6.2.4 Diseconomies of scale – further discussion 199 6.2.5 Economies of scope 201 6.3 The heterodox approach to the behaviour of costs 203 6.3.1 Time and costs 203 6.3.2 The learning curve 208 6.3.3 X-inefficiency and costs 211 6.4 Summary 214 6.5 Some questions to consider 216 6.6 Recommended additional reading sources 218
7 How can the firm set the ‘right’ price? 219 7.1 Introduction 220 7.2 A general framework for thinking about pricing decisions 220 7.2.1 Underlying influences on the behaviour of the firm’s own costs 221 7.2.2 Underlying influences on the behaviour of competitors 221 7.2.3 Underlying influences on the behaviour of potential buyers 222 7.2.4 Underlying influences on the likelihood of new competitors emerging 223 7.2.5 Underlying influences on the behaviour of regulatory authorities 224
7.3 How to define an industry for pricing purposes 225 7.4 The basic elements of the mainstream analysis of the firm’s pricing decision 226 7.4.1 Perfect competition 226 7.4.2 Pure monopoly 236 7.4.3 Imperfect competition 239 7.4.4 Price discrimination 241 7.4.5 Pricing under strategic interdependence 245 7.5 Summary of the mainstream approach to pricing 256 7.6 The heterodox theory of pricing behaviour 256 7.7 Summary 261 7.8 Some questions to consider 262 7.9 Recommended additional reading sources 263
8 How can the firm earn persistent above-normal profits? 265 8.1 Introduction 266 8.2 The heterodox theory of the profit-seeking firm 267 8.3 The evolution of industry structure 279 8.4 Summary 287 8.5 Some questions to consider 288 8.6 Recommended additional reading sources 289
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9 A business enterprise is born 291 9.1 Introduction 292 9.2 Capitalism and risk 294 9.3 Financing the enterprise 296 9.3.1 Alternative financing strategies 296 9.3.2 Making a case to suppliers of finance 298 9.3.3 The Richardson Problem 303
9.4 To make or to buy? 306 9.4.1 Alternative ways of organizing value chains 307 9.4.2 The case against vertical integration 310 9.4.3 The transaction cost analysis of vertical integration/internalization 312 9.4.4 Critique of the transaction cost perspective 316
9.5 Recruiting and retaining staff 321 9.5.1 Why do firms often make it quite difficult to apply for the jobs they offer? 321 9.5.2 Why don’t job contracts spell out more precisely the tasks they entail? 323 9.5.3 Why do ‘leading-edge’ employers sometimes pay less than their rivals? 325 9.5.4 Why do some ‘talking heads’ and bosses earn so much? 326
9.6 The vulnerability of the new business and the importance of goodwill 329 9.7 Summary 335 9.8 Some questions to consider 335 9.9 Recommended additional reading sources 338
10 How can the firm grow? 341 10.1
Introduction 342
10.2
How rapidly will a firm grow? 343 10.2.1 The motivation to grow 343 10.2.2 The relationship between growth and profitability 344
10.3
Growth via contractual linkages 348
10.4
Growth via vertical linkages 351
10.5
Growth via diversification 353 10.5.1 An example and a tool for mapping the strategy of a diversified firm 353 10.5.2 Diversification and economies of scope 356 10.5.3 Synergy and hedging 363 10.5.4 Synergy links are subjective and in need of management 367 10.5.5 Can we make sense of conglomerate firms? 369
10.6
Growth via mergers and takeovers 371
10.7
Inter-firm linkages 374
10.8
Intra-firm linkages: economics of organizational structure 377 10.8.1 The organization problem 377 10.8.2 The U-form structure and its problems 379 10.8.3 The M-form structure 380
10.9
Summary 383
10.10 Some questions to consider 384 10.11 Recommended additional reading sources 386
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11 What can an established firm do when its sales volume stagnates
or declines? 387 11.1 Introduction 388 11.2 The role of slack in the competitive process 389 11.3 Innovation and the competitive process 392 11.3.1 Schumpeter and innovation 393 11.3.2 Innovation, technology and organization – some stylized facts 395 11.3.3 Routines and innovation 407
11.4 Coping with a market in terminal decline 407 11.4.1 The nature of the decision problem in a terminal market 408 11.4.2 Exit barriers 412
11.5 Summary 413 11.6 Some questions to consider 414 11.7 Recommended additional reading sources 414
12 Fundamentals of macroeconomics 417 12.1 12.2
Introduction 418 What does GDP consist of? 419 12.2.1 The output measure of GDP 421 12.2.2 The income measure of GDP 423 12.2.3 The expenditure measure of GDP 424 12.2.4 Adding government to the simple economy 426 12.2.5 Adding foreign trade to the closed economy 428
12.3
The behaviour of GDP over time 429
12.4
The Keynesian cross model of the economy 432 12.4.1 A story about consumption expenditure 433 12.4.2 A story about investment expenditure 436 12.4.3 A story about government expenditure 438 12.4.4 A story about exports and imports 438 12.4.5 Putting the stories together to obtain a model of the economy 441
12.5
The Aggregate Demand–Aggregate Supply model 446
12.6
The basics of government policy intervention 455
12.7
Summary 457
12.8
Some questions to consider 458
12.9
Recommended additional reading sources 459
13 What are the main sources of controversy in macroeconomics? 461 13.1 13.2
Introduction 462 The mainstream perspective on macroeconomics 462 13.2.1 Mainstream analysis of unemployment 463 13.2.2 The mainstream perspective on output and inflation 465
13.3
A roadmap for a journey into heterodox macroeconomics 471
13.4
Flows of funds between sectors 474
13.5
Saving, investment and an ageing population 476
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13.6
Short-term fluctuations in aggregate demand 483 13.6.1 Demand is likely to be function of current income 483 13.6.2 The ‘feel good factor’ 483 13.6.3 Wealth effects 485 13.6.4 Crowd behaviour 486
13.7
Effective demand, unemployment and inflation 487 13.7.1 Expectations and employment 487 13.7.2 The importance of a fractional marginal propensity to spend from marginal income 489 13.7.3 The heterodox perspective on unemployment 490 13.7.4 Heterodox perspectives on inflation 492
13.8
Speculation and business cycles 494 13.8.1 Classical speculation versus movement trading 496 13.8.2 The propensity to speculate is not fixed, nor is the population of speculators 497 13.8.3 Increased risk-taking leads to financial fragility 499 13.8.4 Triggers for upswings and collapses 500 13.8.5 Limits to the fallout when a speculative bubble bursts 501
13.9
Summary 502
13.10 Some questions to consider 503 13.11 Recommended additional reading sources 504
14 The international environment 507 14.1
Introduction 508
14.2
What do we mean by the ‘balance of payments’? 509
14.3
What are exchange rates and how are they determined? 511
14.4
How can firms deal with exchange rate variability? 514
14.5
Why do some firms become multinational enterprises? 517
14.6
Why do firms charge different prices in different countries? 521
14.7
What should a firm do when exchange rates change? 526
14.8
What is the relationship between economic expansion and the structure of a country’s balance of payments? 528 14.8.1 Export-led growth 529 14.8.2 Export-led unemployment – ‘the Dutch disease’ 530 14.8.3 Spiralling foreign debt 530
14.9
Can market forces stop growing foreign indebtedness from becoming a problem? 532
14.10 Why do current account deficits persist even after currency depreciations? 536 14.11 What is the orthodox medicine for countries facing a balance of payments crisis? 539 14.12 Summary 544 14.13 Some questions to consider 546 14.14 Recommended additional reading sources 547
Index 549
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Preface
Once upon a time if you wanted to learn about business you would have been advised to study economics. It used to be pretty much your only option. Nowadays you will probably choose instead to study business administration or business studies and your only exposure to economics is likely to be a compulsory unit called ‘Business Economics’. It is compulsory because it is seen as an essential foundation stone for the rest of your business education, so the content of this unit had better give you the opportunity to learn some useful stuff! That’s exactly what this book aims to do.
Business economics in relation to other business disciplines If you were free to choose, would business economics really be the sort of subject you would choose as part of your training in business? We think the answer is a definite ‘Yes’, because we also have experience of working in other business disciplines. This experience has led us to believe that if you can develop an ‘economic way of thinking’, you will be far better able to appreciate the issues that are dealt with in business disciplines such as accounting, marketing and strategic management. In fact, these other business disciplines owe a great deal to economics. For example: ◆
Cost concepts in accountancy grew out of work by economists at the University of Chicago and the London School of Economics in the 1920s and 1930s (the current state of economists’ thinking in this area of costs is explored in Chapters 5 and 6).
◆
Marketing as a field of academic research grew out of economics in the early twentieth century and the ‘4Ps of marketing management’ (price, product, place and promotion) come straight from economics, namely from the theory of monopolistic competition (which is considered in Chapter 7).
◆
Modern work in strategic management theory draws heavily on economists’ writings on industrial organization, which are considered in Chapters 8, 9, 10 and 11.
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Why use this book rather than another business economics text? From the outset, this book was designed to offer a very different approach to business economics from that presented in existing texts. This is because the authors, the publisher and many lecturers believe that you will be better served by a complete rethink of what a business economics text covers and how the ideas in it are presented. As a result this book offers a pluralistic approach to economics. What does this mean? A typical textbook looks at business economics in terms of just one brand of economic theory and presents it as a definitive, finished product. This theory is typically called mainstream (or neoclassical) economics and it is what virtually all Western economists learn in their first few years of study (hence its ‘mainstream’ tag). The mainstream approach dates from the 1870s but the version employed today is largely due to the independent reworking of it in the 1930s and 1940s by Nobel Laureates Sir John Hicks in the UK and Paul Samuelson in the USA. It lends itself readily to translation into mathematical form, and thereby into numerical exercises that have definite answers. By contrast: A scientist who practises pluralism considers which problems are worth investigating and how to make sense of them in terms of more than one theoretical perspective and does not claim that any one perspective is definitive. As pluralists, then, we will be offering you not just a taste of mainstream economics but also of non-mainstream approaches. We have grouped the non-mainstream approaches under the title ‘heterodox economics’ (contributions to heterodox economics come from the related approaches of behavioural economics, institutional economics, evolutionary economics and post-Keynesian economics). Adopting a pluralistic approach is more intellectually honest than adopting a mainstream-only approach because it does not conceal the existence of alternative points of view. Nor does it fail to confront difficulties in one point of view that have led some economists to construct different ways of making sense of the world of business. With a variety of perspectives at your disposal, you should have a better chance of offering good advice when you get involved with real business decisions. You should at least be able to avoid coming to simplistic conclusions and be well equipped to challenge colleagues who offer them. But, as with everything in economics, this advantage comes at a cost. In this case, the cost is that it initially requires a bit more effort and can seem rather daunting. Pluralistic thinking tends to be unsettling partly because we live in a world where engineers seem to create definite outcomes in the form of machines and appliances that work with a particular degree of reliability, and where managers
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are expected to be able to quantify everything. Most buildings don’t fall down, and most large companies don’t go broke. This probably gives the impression that a science such as economics, which has been around for a couple of centuries or more, should likewise be able to come up with black-and-white answers to economic problems. Here, by contrast, we are promising shades of grey: in other words, a world in which the best way to solve the problems of businesses will often appear to be debatable. It may take you a while to get used to this but the effort will be well worthwhile, because the real world of business – including the quality of engineers’ designs and the numbers that managers work with – is not normally a world of black and white. A good way to start coming to terms with this is to recognize that in other parts of everyday life things are, on a closer examination, not so black and white either. Despite this, and despite often having no formal education in the area in question, we do manage to develop an ability to argue about things, such as the quality of a politician’s or sporting referee’s decision, whether or not a film review was unfair or whether a friend has made a wise career move. If you see the process of studying business economics as entailing gathering tools for arguing about practical problems, and honing up your skills in using them, and if you recognize that you are already quite relaxed about arguing about other debatable areas, then you should find you can proceed with confidence into this book. You should not feel worried that sometimes you may want to use ideas from one variety of economics to look at a problem, whilst at other times you would prefer to use other perspectives: it is a matter of ‘horses for courses’, of developing an eye for a suitable tool for the job at hand. Just be sure to reflect on whether your alternative tools give you grounds for being careful not to claim too much for the results you get with the tool you favour in the context in question. The fact that your instructors have chosen to recommend this text should also inspire confidence that you will be able to handle the challenge of pluralism. Their recommendation is a sign of how seriously they take the pursuit of knowledge about business economics. Instead of resting easily with sets of notes used many times before and problems that have definite answers, they too are working that bit harder on your behalf. They are happy to do so in many cases because they know that the mainstream approach to economics is of limited use when it comes to dealing with many business problems. Despite its limited use we do cover the essence of mainstream economics. We cover mainstream economics for three reasons: ◆
because at times it provides a useful starting point, so long as we keep an eye out for its limitations;
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◆
so that you will know what others are studying;
◆
so that you will be able to cope with elective courses in other areas of economics where the traditional view dominates.
The organization of the book The way we have organized the material in this book was inspired by the work of three great scholars who focused on the process of doing business: (i) Alfred Marshall, who taught economics at Cambridge University at the end of the nineteenth century. (ii) Joseph Schumpeter, originally from Austria, who taught at Harvard University in the middle of the twentieth century. (iii) Harvard University’s Alfred Chandler, the most influential business historian of the past four decades. Marshall was fascinated by the problems that new firms had in securing footholds in their markets, and by the problems that established firms had in remaining innovative and adaptable. Writing shortly after Charles Darwin’s The Origin of Species, Marshall likened the competitive struggle of firms in an industry to plants competing in a forest ecosystem. Schumpeter saw little hope for managers ever to be able to get a peaceful life. This was because he thought the essence of competition between firms was innovation, which meant that an innovation introduced by one rival would require the others to try and hit back with something even better. He called this the process of ‘creative destruction’ and also noted that entire industries could sometimes be thrown into turmoil by one innovation leading to many others related to it. Whilst Marshall’s vision seems to have been inspired by the rise and fall of family businesses of a relatively small scale, Chandler sought to document and make sense of the development of giant corporations from around 1870 onwards. These organizations, run by salaried managers rather than their shareholders, pioneered strategic decision making and worked out solutions to new kinds of problems, such as those of internal organizational design, long before academic theorists had much to say about them. Along the way, these firms developed new capabilities, both managerial and operational, that helped them expand both their scale and diversity of operations, and helped them to keep lobbing new competitive bombshells at their opponents.
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As a result of the influence of these three great scholars this book has an unfolding plot. It is structured around the changing sets of problems that decision makers need to be able to solve at different points in time in order to: (i) get a firm started; (ii) keep the firm in business in the face of growing competitive rivalry; (iii) if they so desire, grow the firm into a much larger operation; (iv) rejuvenate the firm in the face of declining demand. In terms of specific content, Chapters 1 and 2 are essential grounding. In Chapter 1 we take you through some preliminary ideas that are essential for you to begin to see the world through the eyes of a pluralist business economist. In Chapter 2 we discuss markets and their limits and along the way introduce you to the idea of economic model building. Once again this is fundamental material. Firms are created by entrepreneurs, so in Chapter 3 we take a good look at what entrepreneurs do and provide you with insights into what it really means to be an entrepreneur. We begin here with a detailed story of the early days of one of the world’s most famous entrepreneurs – Sir Richard Branson. Despite the rather obvious importance of entrepreneurs in the economy you might be surprised to learn that it is unusual for an economics textbook to dedicate an entire chapter to them. In Chapter 4 we examine how potential customers make their purchasing decisions. If an entrepreneur has had a business idea he or she will have to gain an insight into what makes customers ‘tick’. It is usual in mainstream economics to paint a rather one-dimensional picture of customers, but here we explore their motivations and their decision-making processes in greater detail than a standard business economics text would bother to do. Like Chapter 3, this is an atypical chapter, but the material we cover here should be of more practical use to you than the typical mainstream economic analysis of the consumer. Chapters 5 and 6 are complements in which we examine the kinds of knowledge and resources an entrepreneur needs to have access to in order to set up a business enterprise and the implications his or her choices have for the costs the firm will incur. We begin Chapter 5 with a detailed look at the story of the British entrepreneur James Dyson as a way of grounding the discussion that follows in a real world scenario. We hope that this will help you to see the kinds of problems real world entrepreneurs face in regard to their production decisions and their associated costs and also help you to see the limitations of a purely mainstream approach.
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In Chapter 7 the mainstream approach is used to good effect to tell some simple stories about the kinds of things that need to be taken into account when the entrepreneur is trying to decide on a price for the firm’s product. We also look at the heterodox approach which outlines the practicalities of the pricing problem that are glossed over in the mainstream approach. This chapter marks something of a turning point in the book because subsequent chapters feature much less mainstream economics. Chapter 8 deals with the problem of competitive rivalry: before committing resources and taking the plunge into the market an entrepreneur will need to think seriously about how long the window of opportunity for making healthy profits will be open. Here we introduce the evolutionary theory of the firm and industry to gain deeper insights into how firms can earn persistent profits in a dynamic setting. Having thought about the things covered in Chapters 4 through to 8 the entrepreneur will be in a good position to put together a business plan in order to seek funding for the new enterprise. This is the subject of Chapter 9. In Chapter 10 we examine how an established firm can grow (if the entrepreneur wishes it to) and in Chapter 11 we consider what an entrepreneur or management team can do in order to stave off decline in one or more of its lines of business, or alternatively how it can exit from a declining market. In Chapter 12 we change emphasis from the more microeconomic focus of previous chapters by turning your attention to macroeconomics. Here we introduce you to a baseline macroeconomic model that you can use to understand big issues such as unemployment and inflation and to derive the likely implications for the firm. In Chapter 13 we explore some of the controversies that have cropped up in macroeconomics and, finally, in Chapter 14 we consider international trade, exchange rates and globalization and once again look at implications for the firm.
How to use this book As befits an introductory text, we have tried to break up the economic ideas covered in this book into bite-sized chunks with simple chains of links in explanations of how they work. However, it is in the nature of economics, as a subtle subject that deals with complex systems of interrelationships, that sometimes a point-by-point explanation is not possible and, instead, it is necessary to grasp a set of connected points as a whole all at once. Because of this, you should not presume that you will be able to ‘get’ everything first time around. Some portions, be they sentences, paragraphs or entire sections, may require several attempts before they become clear.
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The pluralistic approach is another complicating factor that will sometimes necessitate dwelling on a particular piece of the text, for sometimes you may find it possible to see one perspective on an issue but be totally unable to ‘get’ another one that is being presented. (The point here is the same as that illustrated by some famous ambiguous diagrams developed in cognitive psychology, such as a rabbit that can also be seen as a duck, or a picture of a wrinkled elderly woman that can also be seen as a beautiful young woman: many people can see one immediately but can only see the other interpretation if it is carefully explained to them, and it is hard to keep both in mind at the same time.) An inability to ‘get it’ is not something that only afflicts students: many debates in economics persist because established ways of looking at the world get in the way of seeing another theorist’s point of view. Often it is useful to get another person’s point of view in such a situation, so don’t be afraid to discuss with your lecturers or tutors any hurdles that you can’t jump yourself. Don’t feel that asking for help is a sign of failure if you have had a serious go at cracking the problem yourself. After all, if teaching materials could be guaranteed to be completely transparent to students, there would be little need for the alternative perspective offered by the lecturer who has chosen to adopt a particular text. Teaching staff would far rather deal with important puzzles at an early stage, rather than try to pick up the pieces close to exam time after you have gone for weeks without having grasped basic points. We also strongly recommend that you form a study group with two or three others to help share ideas about possible interpretations of theory materials and coursework questions. At the end of each chapter we provide ‘recommended additional reading sources’, normally including some brief notes on what particular readings have to offer. We do not expect that you will have the time to follow up most of these but we expect that from time to time you will be intrigued by particular ideas or will have an assignment that requires deeper knowledge of particular ideas. If so, these listings should make it easy to find out more. Like a conventional text in this Internet age, this book has its own website of materials to help you grasp the ideas it covers and get proficient in applying them. We hope you will enjoy using the materials there and find them useful. Finally, we offer what may seem an unlikely piece of advice yet one that we think is very valuable: if you are trying to tackle questions about particular business problems or industries using theory from this book, don’t initially try to gather a lot of information about the particular business or industry. Many students tackle case study problems by ‘researching’ them to find ‘the’ answer, only to end up scoring quite mediocre grades. The problem here lies in the difference
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between information and knowledge (which we discuss in Chapter 1). If you have a lot of information about what is actually going on, it is likely to get in the way of you using your knowledge of economic theory to predict what is likely to be going on. If you have a lot of information you are likely to write answers that involve using commonsense to organize this information without analysing it using economic theory. By contrast, if you have no information from research, all you can do is to try to use your knowledge of economic theory to tell a story about how things are likely to be under various assumptions. If you do this, you are doing economic analysis. Peter Earl and Tim Wakeley
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Acknowledgements
Writing a textbook is a lonely business, but along the way there have been numerous people who have provided us with help and encouragement (sometimes unwittingly!). We would especially like to mention: Stephen Brammer; Mark Grimmer; Eleanor Morgan; Andrew Millington; Paul Osborne; Julian Partridge; Jason Potts; Jennifer and Mike Wakeley. Also, the members of the University of Queensland’s undergraduate and MBA business economics classes, and the students on the various business economics courses at the University of Bath, many of whom provided us with helpful feedback on draft chapters. In addition, the book’s final content has been shaped by the insightful comments received from reviewers of draft versions of the material and it is much better for it. Thank you to: Steve Bradley – University of Lancaster Martin Carter – University of Leeds Douglas Chalmers – Glasgow Caledonian University Roger Fitzer – University of Surrey Frederick Hay – University of Glasgow Geoffrey Hodgson – Debra Johnson – University of Hull Gerald Steele – University of Lancaster Harjinder Virdee – Southampton Institute Pam Whisker – University of Plymouth David Williams – Nottingham Trent University Thanks also go to the team at McGraw-Hill – Kirsty Reade, Emily Jefferson, Eleanor Hayes and Catriona Watson. Peter Earl and Tim Wakeley
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Guided Tour 4 Who wants the product and in what quantity? Learning outcomes If you study this chapter carefully, it may help you to understand: ◆
the impact that the context of a purchasing decision has on the problems with which buyers have to deal
◆
why the mix of goods purchased changes as incomes change and as technological progress occurs
◆
how different purchasing decision rules work and why they matter for business policy
◆
the economic significance of both changes in fashion and the ‘lifestyle’ concept
◆
why there are both similarities and differences in the ways that consumption and business purchasing decisions are made
◆
what is meant by, and what determines, ‘brand equity’ and ‘brand loyalty’.
Learning outcomes Each chapter opens with a set of learning outcomes identifying the key concepts that will be covered within the chapter.
To the extent that you develop such understanding, you should be better able to: ◆
provide advice on which questions market researchers should ask in a particular context
◆
critically appraise alternative proposals for changes to product designs, prices and methods of promotion and distribution.
Introduction
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CHAPTER 7 HOW CAN THE FIRM SET THE ‘RIGHT’ PRICE?
7.1 Introduction Setting the ‘right’ price for the firm’s product is an important determinant of its economic success. Intuitively we know that the firm will lose sales if it charges a price that is too high and its profits will suffer. On the other hand, if the firm charges a price which is too low it may forego profits that it could have earned, or even fail to cover its costs and make losses. In this chapter we will draw upon what you have learned so far to discuss the firm’s pricing decision. To keep things simple we will assume that the firm produces only one product, so we will not discuss the complicating factors that might enter into the pricing decision of a multi-product firm. Before we proceed we will introduce some basic concepts that will underpin what follows. Specifically, these basics are a general framework which can be used to think about the firm’s pricing problem and guidance on how to identify those competitors who are relevant to the firm’s pricing decision.
An Introduction sets the scene for the reader and introduces them to the issues that will be addressed in the chapter.
7.2 A general framework for thinking about pricing
decisions We begin the analysis of pricing decisions by stating formally the relationship between revenues, costs and profits: Profit (π) = Total revenue (TR) minus Total costs (TC)
[i]
If we examine the constituent parts of expression [i] we obtain expressions [ii] and [iii]: TR = P × Q
[ii]
Expression [ii] states that the total revenue earned by a firm depends upon the price, P, it charges for its good/service and the volume of sales, Q, it can achieve at this price. In other words, it depends upon demand from customers. TC = TFC + (AVC × Q) = ATC × Q
[iii]
Expression [iii] states that the total costs incurred by a firm consist of its total fixed costs (TFC), which are independent of the number of units it produces (and which include the entrepreneur’s opportunity cost), and its total variable costs (TVC), which depend directly upon the number of units produced. As a minimum requirement the problem for the entrepreneur is to choose an asking price for the firm’s product that will generate enough revenue to enable it at least to cover its costs of production. In order to do this the entrepreneur must take account of five important factors:
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CHAPTER 4 WHO WANTS THE PRODUCT AND IN WHAT QUANTITY?
Such a situation is less likely to arise if a would-be supplier can communicate with other interested and potentially influential people within the organization – such as workers who actually have to use the machine in question, or the marketing manager who could benefit from a more consistent standard of manufacturing quality if it were adopted – and seek to demonstrate that the firm risks a mediocre deal if it sticks with its established supplier. This may be no easy task, particularly if they first have to get their personnel or promotional materials past the potential customer’s gatekeepers, such as their secretaries or personal assistants.
4.8 Brand loyalty and brand equity Mainstream theorists have had little place for the concept of a ‘brand’, tending to construct models of choice in which buyers are choosing between precisely differentiated products and have precise wants. A brand is defined as a name or symbol that consumers see as signifying something particular about the nature of a product and those who consume it. Brands serve the role of shorthand product summaries for boundedly rational buyers who are sufficiently knowledgeable to decode them. Global brands such as McDonald’s, Kodak, Nike, Sony or IBM enable internationally mobile consumers immediately to achieve some sense of familiarity, rather than feeling like totally clueless, recently arrived aliens, when they try to make choices in a new location. Such brands are, in short, devices that enable us to simplify the process of choice by generalizing across time, space and (when a ‘brand extension’ is successful) different types of products. They are like friends to which we turn for assistance in moments of need and, so long as they do not let us down too much, we tolerate their occasional lapses.
Important concepts/ideas These are highlighted throughout each chapter and provide key points for ease of reference.
Brand loyalty may range from passionate commitment to particular brands, that buyers are prepared to defend publicly, down to much more common but rather loose polygamous attachments to a number of suppliers of a particular kind of product. The notion of brand loyalty is clearly at odds with the mainstream ‘field’ perspective, for it suggests that buyers form relationships of various kinds with particular brands and steer well clear of others. In the case of polygamous brand loyalty, there may be a hierarchy of brands that a consumer is prepared to consider if they are available, based on previous experience with them. But often, any of the consumer’s favoured brands is seen as acceptable, with choices between them being triggered by the particular juxtaposition of circumstances, such as
Illustrative boxes
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CHAPTER 7 HOW CAN THE FIRM SET THE ‘RIGHT’ PRICE?
Box 7.3 Marginal revenue and the downward sloping demand curve
Extensions and applications are placed in boxes throughout the text in order to help students appreciate better the practical significance of the adjacent models and theoretical discussions.
If the firm faces a downward sloping demand curve then marginal revenue, MR, will be less than the price (or average revenue, AR). To see this, consider the following simple data set: Output Q
Price P
Total revenue TR
Average revenue AR (=TR ÷ Q)
1
10
10
10
2
9
18
9
3
8
24
8
4
7
28
7
5
6
30
6
6
5
30
5
Marginal revenue MR* 8 6 4 2 0 –2
7
4
28
4 –4
8
3
24
3
(* MR is defined as ‘the addition to total revenue from selling one extra unit of output’.)
If we plot the demand curve and the MR curve we obtain the following graph: Price, Cost MR curve is twice as steep as AR curve
10 8 6 4 2
Demand (AR)
0 –2 –4
1
2
3
4
5
6
7 MR
8
9 Quantity of output, Q
Why is MR < P? Because when a firm faces a downward sloping demand curve higher quantities of output can only be sold if the price of every unit is
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Figures and tables
12.2 WHAT DOES GDP CONSIST OF?
other goods and services) are levied on a household’s expenditure. If a household earns a specific level of income (and remember that household income includes the profits made by firms) then it cannot legally avoid paying direct taxes to the government. In contrast, the total amount paid as indirect tax can be reduced if the household decides to consume lower quantities of the products which are taxed in this way. If you think in terms of the circular flow of income, taxes represent a leakage from the system, but this money finds its way back into the system via two routes: the first is government expenditure (G) on goods and services (e.g. the police, the armed forces, nurses, etc.) and the second is in the form of welfare payments (W). Welfare payments are more generally called transfer payments: this is because the government does not spend this part of its tax revenues itself, but instead it redistributes it to households which add it back to their income and spend it according to their own needs. The income households have to spend on goods and services – their disposable income (Yd) – is therefore equal to gross income (Y) + transfer payments (W) – direct taxes (Td). Figure 12.3 shows the circular flow of income amended for the inclusion of government.
Each chapter provides a number of figures and tables to help you to visualize the various economic models, and to illustrate and summarize important concepts.
I
C
G
S Households
Y + W – Td
Government
W
Te
C + I + G – Te
Firms
Td
Y
Key: Y = income C = consumption expenditure I = investment expenditure S = household saving G = government expenditure Te = indirect taxes Td = direct taxes W = transfer payments
Figure 12.3 The circular flow of income for a closed economy
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CHAPTER 13 WHAT ARE THE MAIN SOURCES OF CONTROVERSY IN MACROECONOMICS?
or to allow existing loans to be rescheduled without the supply of new loans being disrupted. However, central banks face a dilemma when trying to limit the fallout from a speculative bubble: there may be an undesirable long-run impact on prudential behaviour if it becomes too obviously clear that debt does not carry responsibilities and repayments can be pushed further and further into the future. They may also experience problems in co-ordinating their policies in a hurry on a global basis.
13.9 Summary In this chapter we have considered two sharply contrasting perspectives on macroeconomics. From the perspective of mainstream economics, the macro-economy is really nothing more than an aggregation of individual markets with the added complication of the government being able to affect total spending via its policy interventions. If there is unemployment, it is the result of wages failing to fall when the overall volume of spending falls, and if the general price level is increasing this is due to excess demand, itself a consequence of too much credit being made available. The heterodox perspective takes the view that, 70 years on, there is still much of relevance in John Maynard Keynes’s theory of employment. Keynes emphasizes the extent of scope for co-ordination failures due to savers not signalling to firms what they will eventually want to buy when they spend their savings, and money that is saved not necessarily generating more lending to businesses. Firms have to guess how much to invest to expand output in the future, and how much will be demanded from their current outputs. These guesses determine how many workers they want to hire. If they are pessimistic, they will limit their production and their capacity expansion, and fewer workers will be hired. If fewer workers are hired, consumption demand will be reduced, though not by as much as income, so an initial contraction of activity does not typically turn into a macroeconomic implosion. Bubbles of speculative activity compound swings in output and employment from time to time, but since speculators tend to focus on assets whose supply cannot easily be expanded, these bubbles tend to affect production levels indirectly to the extent that they change speculators’ perceptions of how wealthy they are. Heterodox economists do not regard ‘labour market reforms’ aimed at producing softer wage bargains as an effective means of
End of chapter summary This briefly reviews and reinforces the main topics the authors have introduced in each chapter to ensure that students have acquired a solid understanding of the ideas covered.
Some questions to consider
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CHAPTER 10 HOW CAN THE FIRM GROW?
10.10 Some questions to consider
End of chapter questions encourage students to review and apply the knowledge acquired from each chapter. The exercises range from short answer to longer essay-style questions offering a range of assessments for test and exam practice.
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CHAPTER 5 HOW SHALL THE FIRM PRODUCE THE PRODUCT?
5.7 Recommended additional reading sources For the story of how some of the world’s major businesses have coped with the problems of production, see Alfred Chandler (1977) The Visible Hand: the Managerial Revolution in American Business, Harvard, Belknap Press.
Recommended additional reading sources
The Dyson story is told in great detail by Giles Coren (2002) James Dyson Against the Odds: An Autobiography (New edition), London, Texere Publishing. All of the Dyson quotations used in this chapter are taken from this book. For an interesting view of the theory of production, see Nicolai Foss (1997) ‘The classical theory of production and the capabilities view of the firm’, Journal of Economic Studies, 24, no. 5, pp. 307–23. A more advanced discussion of some of the topics we have covered in this chapter is provided by Richard Langlois (1999) ‘Scale, Scope and the Reuse of Knowledge’, in S.C. Dow and P.E. Earl (eds) Economic Organization and Economic Knowledge: Essays in Honour of Brian J. Loasby, 1, Cheltenham, Edward Elgar, pp. 239–54. Another advanced discussion of the topics we have covered in this chapter, which is complementary to Langlois’ article, is given by Axel Leijonhufvud (1986) ‘Capitalism and the factory system’, in R.N. Langlois (ed.) Economics as a Process: Essays in the New Institutional Economics, New York, Cambridge University Press, pp. 203–23. Our discussion of types of knowledge and the production function was informed by Brian Loasby (1999) Knowledge, Institutions and Evolution in Economics, London, Routledge (see Chapter 4, ‘Capabilities’, pp. 49–68). The original account of the division of labour can be found in Adam Smith (1776/1986) An Inquiry into the Nature and Causes of the Wealth of Nations, London, Penguin Books (see Book 1, Chapters I–III).
A list of sources appears at the end of each chapter, pointing students towards books and articles that can explore the ideas in the chapter in further depth. The authors provide a brief synopsis of each suggested reading.
1. In contrast to the UK and northern Europe, domestic swimming pool maintenance is a sizable industry in Australia. Residents of a typical Australian suburb can normally choose between several specialist shops to buy equipment and pool chemicals, as well as being able to purchase some pool chemicals from supermarkets and hardware stores. If you had just arrived in Australia with no previous experience of this sector, would you be surprised to discover that franchise networks such as Poolwerx (see www.poolwerx.com.au) and Swimart (see www.swimart.com.au) dominate the market? Explain your economic reasoning. 2. The phrase ‘McDonaldization’ was coined by sociologist George Ritzer (2000) (in The McDonaldization of Society, Thousand Oaks, CA, Pine Forge Press) to denote the application of McDonald’s-style business practices to a wide range of products beyond just hamburgers. These processes involve the use of highly programmed production methods to simplify production tasks for staff and bring calculability and predictability to production processes. Ritzer sees the higher education sector as one that is succumbing to this process. What limits the extent to which the principles of the fast-food restaurant can be applied to the supply of higher education services, particularly in the case of universities seeking to have their programmes offered at sites in other countries? 3. Imagine you are on the board of a tyre company and your fellow board members are debating whether or not the next phase of the firm’s expansion should be (a) to integrate backwards into rubber plantations; (b) to diversify into producing rubber belts and hoses for the automotive sector; or (c) to diversify into the production of chemicals for use in solventbased adhesives. Explain how you would use your training in business economics to contribute to this debate. 4. Nokia’s pre-eminent position in the mobile phone handset market may seem remarkable given the firm’s earlier history in the forest products, rubber and cable industries (see www.nokia.com). One of its major competitors, Ericsson, gave up producing mobile phone handsets to concentrate on telephone systems but has recently formed a 50:50 joint venture company with Sony, called Sony Ericsson Mobile Communications AB (SEMC), and both firms are investing heavily in it. In the light of material
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Technology to enhance learning and teaching Online Learning Centre (OLC) After completing each chapter, log on to the supporting Online Learning Centre website. Take advantage of the study tools offered to reinforce the material you have read in the text, and to develop your knowledge of marketing in a fun and effective way. Resources for students include: ◆
Chapter by Chapter Learning Objectives
◆
Solutions to Review Questions
◆
Useful Web Links
◆
Chapter by Chapter Self Tests
◆
Glossary
◆
Chapter by Chapter Crosswords
◆
Specimen Exam Papers
Also available for lecturers: ◆
Lecture Outlines
◆
Futher Reading
◆
PowerPoint Slides
◆
Testbank
◆
Artwork from the Textbook
For lecturers: Primis Content Centre If you need to supplement your course with additional cases or content, create a personalized e-book for your students. Visit www.primiscontentcenter.com or e-mail primis
[email protected] for more information.
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1 Introduction
Learning outcomes If you study this chapter carefully, it may help you to understand: ◆
the nature of ‘the economic problem’ and what is meant by opportunity cost
◆
that economic analysis requires skill in knowing which questions to ask about the situation being analysed, not just ability to provide answers
◆
the differences between a variety of problems of information and knowledge that complicate the process of business decision making.
To the extent that you develop such understanding, you should be better able to: ◆
develop a willingness to embrace tasks that involve open-ended problems rather than ones that are ‘black and white’ with welldefined solutions
◆
enjoy studying business economics.
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CHAPTER 1 INTRODUCTION
1.1 Introduction In this chapter we are going to introduce you to some fundamental concepts that will crop up throughout the rest of the book. In writing it we have assumed that you have read the Preface to the book and so are familiar with the idea that we adopt a pluralistic perspective. If you have not yet read the Preface, please do so now. If you find that you are becoming confused by discussions in later chapters you might find it useful to revisit the material in this chapter in order to ‘get back to basics’.
1.2 The economic problem Economics is normally defined as the study of how decision makers choose to allocate resources between alternative uses. The resources in question can take a variety of forms: ◆
Financial resources: cash, bank deposits, loans and securities that might be sold to raise money.
◆
Physical resources: land, buildings, durable goods such as machines and appliances, tools and furniture, and perishable products such as food.
◆
Human resources: the decision maker’s own time and skills, and those of other people whose efforts can be called upon by the decision maker.
Most resources are only available in limited quantities at any point in time: in other words they are scarce. The ‘economic problem’ centres on how to allocate these scarce resources in ways that do not leave a trail of missed opportunities for doing something better with them. For example, consumers have to choose between work and leisure, and between using their pay to rent or buy a home, to spend it on goods and services, or to save some of it in order to spend it at some point in the future. Likewise, governments have to choose between spending more on defence or more on education, social welfare, better roads and so on. In the process of using resources learning may occur, not merely when resources are devoted to education but also in the process of consumption and in organizations. The choices of how to use scarce resources today may thus affect the resources available to allocate in future (since the pool of skills available may change), and what people want to do with them. Among the kinds of resource allocation decisions that people involved in business have to wrestle with are the following: ◆
Shall I work for someone as an employee, or shall I start a business and be my own boss?
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1.2 THE ECONOMIC PROBLEM
◆
What shall we make?
◆
What production method shall we use – for example, shall we use human inputs or replace them with machines?
◆
How many units of each of our product lines should we produce and when should we stop producing something altogether?
◆
Should we set up a factory overseas?
◆
Should we make our own inputs or should we concentrate on assembling inputs purchased from other businesses?
◆
Should we market and distribute our product ourselves, or should we get another firm to do this on our behalf?
◆
Should we spend more on research and development rather than on marketing?
◆
Should we expand the size of our business by building a brand-new factory or by taking over an existing business?
Ways of addressing all of these problems of choice – and many more – are the domain of business economics. The economic analysis of choice begins with a very simple proposition: everything has an opportunity cost. In terms of everyday speech, this proposition is captured by the expression ‘you can’t have your cake and eat it’. The opportunity cost of doing something is the value you place on what you would have done if you had not been able to do what you actually chose to do. If you have a piece of cake, it can either be sitting on a plate uneaten, or it can be inside you because you have eaten it; it cannot, in its entirety, simultaneously be both on the plate and inside your stomach. Where it is results from your choice. Now suppose that, although you would rather eat the cake right now than leave it on the plate, you instead choose to give it to a friend: if so, the cost of the gift of cake is the value you would have derived if you had consumed it yourself right now. So, even if you did not have to buy the cake, the act of giving it to someone else has a cost. If you baked the cake yourself to give to your friend, then there is an additional opportunity cost to the gift: the time you spent baking the cake could have been used to do something else, such as spend some time at the gym, or bake something else. Even from the cake recipient’s standpoint, the cake has a cost: if they eat it, it gets in the way of eating something else at that time; if they choose to defer eating it, storage space is required. To put it another way, ‘there’s no such thing as a free lunch’, even when the gift carries no return obligations.
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CHAPTER 1 INTRODUCTION
Opportunity costs exist in the minds of those who incur them; they cannot be observed directly. If we cannot ask decision makers about how they see their opportunity costs in a particular context, economic theory may provide us with clues as to how they may be thinking. What determines a choice is how opportunity costs are seen at the time of choosing, but with hindsight they may look very different: we suffer regret when we realize just how much we gave up to get what we got, or we rejoice because we are surprised at how much we got and can now see how bad things would have been had we chosen the option we had judged was the next best thing. So, the hallmark of the economist is a focus on opportunity costs, on different ways of doing things with a given set of resources. This involves being adept at lateral thinking as a means of expanding the menu of possibilities and it is not something that you will find yourself doing automatically in your first couple of weeks’ studying business economics. But once you get there, you should find it easier to achieve high grades in other business subjects and you should gradually become able to analyse all manner of everyday situations and business problems in ways that are not available to the ‘person in the street’. As a student of business economics you will be developing skills that lead you automatically to ask: ◆
What does economic theory lead me to expect in this situation?
◆
Is there another way things could be, or could have been, done, or different ways of using resources?
◆
What does economic theory predict would be the likely costs and benefits of these alternatives?
In other words, how you see costs and benefits of particular actions will be shaped by your knowledge of economic theory; you will take nothing at face value; and you will develop a better understanding of the facts presented to you by questioning everything, even in situations where a firm is clearly being very successful.
1.3 An example of the ‘economic way of thinking’ Let us take a simple example of how this superior question-asking ability of the business economist leads to an awareness of issues that the untrained eye might not notice. Our example is chosen quite deliberately to seem a long way from familiar territory for most readers and to have as its subject something that at first sight does not appear to be a ‘business’ issue.
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1. 3 AN EXAMPLE OF THE ‘ECONOMIC WAY OF THINKING’
Suppose you and a friend are backpacking around Australia after graduating and your friend is taken ill and ends up in the publicly funded Royal Brisbane Hospital. As a business economist in a foreign land, consider what you might think when, during a visit to your sick friend, someone comes around with a clipboard and cashbox and asks your friend if they would like to pay a particular sum to have the television above their bed connected for the next day or two and, if so, whether they would like to pay an extra daily sum to have access to the Foxtel cable television network as well. A background in mainstream economics might lead you to consider how the number of days of television access requested by patients might vary depending on differences in prices that were charged, and which would be the most profitable price to charge given the costs associated with providing the service. This would lend itself very nicely to mathematical analysis if the relevant numbers were available. However, the kind of wide-ranging way of thinking that we are encouraging you to adopt ought to lead you to wonder about additional questions, such as: ◆
Who, apart from Foxtel, is making money from the television rental service – the hospital or some private company, or both?
◆
Would it be better for the hospital to own the televisions and cabling, and merely allow a private contractor to run the service?
◆
If a private contractor is involved, what kind of contract underlies the deal with the hospital – for example, how long a period does it cover, and is there some flat fee/daily royalty payment to the hospital? What sorts of arrangement would make the most sense from the point of view of the hospital and the contractor, and which would both find satisfactory?
◆
Should the hospital include some kind of price regulation in such dealings, given that the patients are dealing with a monopoly supplier and may not even be in a fit state to make rational decisions?
◆
Would it be a good idea to have the television hardware set up so patients can choose between rival providers of viewing access and cable channels?
◆
Might it not be less wasteful to have patients nominate their television preferences on the same form as they nominate their meal preferences, and to present them with a single bill at the time of leaving the hospital?
◆
Why not simply provide patients with free access to free-to-air television as part of the general range of services provided by the hospital at no specific charge, as part of the process of aiding the patients’ speedy recoveries? And so on…
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CHAPTER 1 INTRODUCTION
This example brings out two themes that you should keep in mind as you study business economics. The first is that the task of managing an organization basically entails economizing. This means trying to work out ways of improving a person’s or an organization’s well-being without wasting resources that are limited in supply and that can be employed in diverse ways and by different organizations. The example concerns decisions about strategic management – the range of activities the hospital is going to be involved with, and how it will be involved with them. However, managers wrestle with problems of allocating scarce resources at every turn, whether they are involved in forward planning or in solving unexpected problems, such as breakdowns, disruptions to supply, sudden changes in the business climate or product defects. The second thing to note about the example is that it implies that expertise in business economics is relevant for those involved in not-for-profit organizations, such as public hospitals, every bit as much as for managers of a corporation such as General Motors or IBM. If we think further about the resource allocation problem faced by hospital administrators the issues that arise are basically the same as those faced by, say, a car manufacturer: ◆
Would it make sense to close down small regional hospitals and consolidate care in larger hospitals in major cities where specialist staff and equipment can be employed to full capacity? (Should manufacturing operations be consolidated into fewer, larger factories?)
◆
How many hip replacements should be sacrificed to do a heart transplant? (Would it be better to spend limited investment funds on improvements in engines or interiors?)
◆
Will better quality hospital food and cleaning services be available, and at lower prices, if these inputs are provided by independent contractors? (Should fuel injection systems be made in-house or purchased from another firm?)
So, although we might be somewhat nervous about hospitals hiring former carindustry executives for senior management positions, a requirement that medical staff should study for business economics or MBA degrees if they wish to become hospital administrators should not be seen necessarily as a sign that patients will be treated in a dehumanizing manner.
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1.4 PROBLEMS OF INFORMATION AND IMPERFECT KNOWLEDGE FACED BY DECISION MAKERS
1.4 Problems of information and imperfect
knowledge faced by decision makers [T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don’t know. US Defense Secretary, Donald Rumsfeld (2003) Associated with our adoption of a pluralistic approach to business economics is an emphasis on how resource allocation is affected by problems of too much or too little information and imperfect knowledge. The resource allocation problem is not a problem merely because the supply of resources is limited. It is also a problem because decision makers often find it difficult to work out what to do with the scarce resources. This means they run the risk that they will waste them, with the result that they, or the people for whom they are working, end up being worse off than if it had been obvious what the consequences of making particular choices would be. Resources are difficult to allocate because decision makers suffer from a number of limitations in respect of information and knowledge. Because of this, it is often unwise to try, as a typical mainstream introduction to economics does, to reduce the resource allocation problem to a series of well-defined issues that assume problems of information and knowledge do not exist (you will see examples of the mainstream approach, which makes extensive use of graphical analysis, later in the book). If this seems like bad news in terms of economics looking more complicated if it attempts to get to grips with problems of information and imperfect knowledge, the good news is that economics becomes a much more exciting and engaging subject once these problems are recognized. In particular, the decisions of entrepreneurs and business strategists can often seem quite heroic because, at the time of choice, the quality of the decision cannot be known and there is scope for things to turn out spectacularly well or go horribly wrong. Let us now consider the forms these problems of information and knowledge take, as a foundation for the rest of the book. First, though, we must comment on the distinction between information and knowledge since these are terms that are often used interchangeably. We see knowledge as having a slightly different meaning from information and normally use knowledge in relation to an individual’s capabilities or understanding, picked up from experience and shaped by the way the person looks at the world. A person can be given a piece of information and have no idea of its significance unless given many other pieces of information that enable it to be interpreted in context. The person with
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CHAPTER 1 INTRODUCTION
knowledge has a way of linking pieces of information together to extract meaning from them or to be able to do something with them. Put it another way, you might see this book as containing a lot of information about business economics, but reading the book does not guarantee you will end up with a functional knowledge of business economics; such knowledge depends on what you make of the information we present here and the capacity you develop for using this interpretation to take business puzzles to pieces and suggest solutions to them. 1.4.1 Varieties of problems of information and knowledge The definitions presented below deserve careful attention, for the terms that we differentiate are often muddled together in everyday speech. The examples that accompany them should help you further to see the rich array of problems that come under the broad ‘information and knowledge’ heading. Risk
A situation is said to be risky when the decision maker does not know what is actually going to happen at a particular point in time but does know the probability that a particular thing will happen – in other words, that it will happen with a particular frequency in a particular number of periods, or in a particular population. For example, an insurance company does not know whether houses in a particular area will be flooded in a particular year, but it might expect the locality to be flooded once a century. Likewise, it may not know precisely which drivers in a particular risk category will have a crash resulting in a claim of a particular amount in the next year, but it typically does have a very good idea about the percentage that will do so. From this standpoint, insurance normally is not a particularly heroic kind of business. Uncertainty
Many economists treat uncertainty and risk as if they mean the same thing. In this book, however, they mean very different things. Decision makers are uncertain when they are aware that they do not know what will happen in a particular situation or what could happen, or are aware that they do not know, or are unable to calculate relevant probabilities or that these are not relevant since they only get one chance to achieve a particular outcome. An obvious example of an uncertain event is a third World War: such a war never materialized during the Cold War era despite many people worrying about it as
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a possibility. It might never occur at some point in the future; but then again, it might happen one day. We simply do no know whether such an event will occur and hence it is completely inappropriate to see it in terms of risk. Likewise, it does not make much sense to say ‘I have a one in a hundred chance of getting this job’ if you know that 99 other people have also applied: you either get the job or you do not. In any case, prospective job applicants often have little idea how many other applicants there will be. Even if the selection criteria for a job have been spelt out to potential applicants, those who apply may be unclear just how problematic it might be to fail to meet particular ‘desirable’ or ‘essential’ criteria, or how they will be seen in respect of them. Perhaps none of the applicants will have what is required, but how can any would-be applicant know? The business of insurance becomes much more heroic when the business environment suddenly changes so that established probabilities are questioned and nasty surprises suddenly seem possible. This happened in the UK car insurance market in the late 1980s/early 1990s when thieves unexpectedly started taking large four-wheel drive vehicles for use as ram-raiding tools and there was a great increase in the theft of high-performance cars for joy-riding purposes. The insurance companies found it very hard to know whether these were temporary phenomena, or even whether they had yet seen the worst of what they should come to expect on a regular basis. Their lack of willingness to make heroic guesses led to some brands of vehicle becoming virtually uninsurable. Ongoing debates about genetically modified foods and climate change are driven by uncertainty. The anti-genetic modification lobby worry about unspecified mutations and side-effects from consuming genetically engineered foods, while scientists with different models of climate change argue about whether we are definitely experiencing a new climatic trend and what is necessary in terms of reduced greenhouse gas emissions to stabilize temperatures. Sceptics deny the existence of these problems but cannot demonstrate this definitively. It is crucial to avoid errors here, since if the sceptics are wrong, some of the damage may be not be reversible for many generations, or not at all. Ignorance
Confucius posed the question, ‘Shall I tell you what knowledge is?’ He answered, ‘It is to know both what one knows and what one does not know.’ In a state of ignorance, by contrast, as Donald Rumsfeld famously put it more recently, decision makers may have some ‘unknown unknowns’: Ignorance is a lack of awareness of the limits to one’s knowledge.
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For example, consider the role of ignorance in determining a person’s disappointment with a change of jobs. At the time of choosing to accept the job, the person might have worried about a number of issues only to find in the event that these worries were unfounded. However, there could have been nasty surprises due to things that they did not even consider at the time of the choice or in respect of which they perceived no uncertainty but which proved to be very different from their expectations (as in, ‘I had no idea that …’). The worries were caused by uncertainty, the nasty surprises by ignorance. Although ignorance is often a cause of regret, its potential positive role as a source of rejoicing should not be ignored. Indeed, it is possible that partial ignorance is an essential ingredient in bold decisions in the business world: if entrepreneurs thought really carefully about the sheer range of things that could go wrong with their ventures, many of them might have decided against investing in particular schemes that actually proved to be successful. If decisions are often made in a state of ignorance, then improved resource allocation may depend on developing a capacity to make the best of a situation, such as building flexibility into one’s plans and ways of thinking. Flexibility comes, of course, at a cost and to know whether the cost is worth incurring decision makers need to have an idea of their potential fallibility in broad terms even if they cannot develop a capacity for uncovering specific kinds of uncertainty at the time decisions are being made. Information asymmetry/information impactedness
A situation of information asymmetry is said to exist if parties to a deal differ in the amount of relevant information that they possess. In many cases, this is a result of some people strategically ‘keeping their cards close to their chest’ rather than sharing information with those who need it. A person who is selling something may know more about it, from personal experience of using it, than the prospective buyer does, though sometimes it is the buyer who has a better idea of the nature of the product due to expertise in the particular market compared with the ignorance of the seller. Sometimes, a problem of asymmetric information can be resolved if the information-deficient party incurs costs of buying information from a third party, as when a person gets the Automobile Association (the AA) to inspect a car they are considering buying. But sometimes, like an impacted wisdom tooth, relevant information may be very hard to get at. A state of information impactedness exists where one party to a deal judges that the other has relevant information which cannot be uncovered without a significant cost being incurred, or which cannot be uncovered at all.
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For example, even the AA’s mechanics may fail to discover problems in a used car, such as those that are of an intermittent nature or are only evident if the vehicle runs for a significant period of time. Closely related to information impactedness is the notion of opportunism, which brings us close to the territory of business ethics, namely the study of the kinds of business behaviour that are morally appropriate in particular circumstances. Opportunism is the guileful, self-serving exploitation of an information advantage. Opportunism is not just the preserve of some used-car sales people, or officials in firms such as Enron or Worldcom that for a time manage to use ‘creative accounting’ to keep their firms from appearing insolvent. It also occurs when workers perform below the maximum rate they would deliver if they were being monitored more closely, or when someone knowingly tries to pass to others the blame for a problem that has come about due to their own sloppiness or incompetence. Information overload
While the absence or inaccessibility of information that could be relevant to choice may make decisions problematic or cause regret, decisions can also prove difficult because seemingly relevant information is very easy to come by. Compared with super-computers, human beings can only process information slowly: in most situations we can do the equivalent of answering no more than about ten ‘yes’ or ‘no’ questions in a second. (Skilled musicians and typists can identify notes or letters rather faster than this by seeing groups of them in chunked form.) Added to this is the limiting factor known, after cognitive psychologist George Miller, as Miller’s Rule: we can only keep in mind 7 ± 2 things at once. Information overload is the term used to describe situations in which decision makers have access to so much information that they cannot reach a decision at all, or can only reach a decision by consciously or unconsciously discarding some of the information and focusing on the rest. With many decisions, such as the task of buying a car or a house, or deciding which worker to hire from a thick pile of applications, we tend to face more than ‘about seven’ options and each option tends to have multiple dimensions, so we are likely to suffer from information overload. In principle, shopping via the Internet enables us to avoid missing opportunities due to ignorance, but it opens up massive scope for information overload as we try to keep in mind all the things that we discover to be available.
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Tacit knowledge
One person’s ability to make a decision or undertake a task may be hampered by the limited ability of someone else to spell out something of relevance to that task. The person may know what they want, or how to do something to a high standard, but have trouble putting it into words (‘It’s sort of like…’). If so, we say that there is a problem of tacit knowledge. Tacit knowledge is knowledge that a person may be willing to share with others but which they cannot articulate in a manner that accurately conveys it in a manner that other parties can grasp. This includes situations in which people are able to perform a particular task but do not know how they do so. Many things require a ‘knack’ and even if we have it, we don’t always know what it entails; we just perform the task automatically, without even thinking. Teachers face the tacit knowledge problem frequently, whether they are trying to teach a subject such as business economics or rocket science, or are merely trying to show someone how to ride a bicycle, play a musical instrument or swim. In business, tacit knowledge can be an issue in terms of marketing communications (getting across a message about the nature of the product or understanding what customers want), transferring established technology to new branches of a firm, or in licensing technology to another organization, and getting the best out of workers who have recently joined a business. Often, the tacit knowledge problem can only be overcome by working alongside the mentor who has the expertise (‘learning-by-doing’), or spending time getting to know a client’s situation to find out their needs. Bounded rationality versus global rationality
Taken together, these problems of information and knowledge lead to a view of decision makers as acting with what Herbert Simon, winner of the 1978 Nobel Prize in economics, called bounded rationality. A person is said to be acting in a boundedly rational manner when they are acting purposively and trying to make good decisions despite the fact that it is impossible for them to know what the best decision would be in the circumstances because they are not clear what their circumstances are or what the problem they face really is. From the standpoint of much of the heterodox economics used in this book, it seems reasonable to see the idea of economizing as being about what Herbert Simon called ‘satisficing’ behaviour – in other words, it is about how people try to find satisfactory solutions to perceived problems and meet particular performance targets. If a target seems to be impossible to meet, then from this
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standpoint it seems perfectly reasonable to lower it. On the other hand, if targets seem to be easy to meet, then it seems to make sense to set them a bit higher, using a simple rule as the means of judging when and how much to change them. Mainstream economists, by contrast, prefer to characterize economic problems as if decision makers can formulate and solve them in an optimal manner – in other words, as if decision makers can see the whole picture and are ‘globally rational’. Global rationality is said to prevail in situations where decision makers face well-defined problems (certain or, at worse, risky in the sense of having known probabilities), with a well-defined set of possible solutions, and can identify these problems at the right time and work out the best thing to do in respect of whatever their goal happens to be. Given the list of problems of information and knowledge that has just been presented, this may seem rather unlikely in reality. Few of the economists who assume optimizing behaviour and global rationality would deny the challenges that decision makers have to deal with when allocating resources. Rather, the conventional wisdom is based on a ‘survival of the fittest’ idea. Skilled decision makers who set out to maximize profits or those who happen, purely by chance, to maximize profits will drive out of business those who merely set themselves workable targets and adjust those targets up or down in the light of what seems to be possible. In other words, in the jungle of the market, optimal behaviour drives out satisficing behaviour. Behavioural and evolutionary economists do not accept this line of thinking. They point out that to survive in a competitive arena one does not have to perform at the highest possible level. All one has to do is to match current performance standards on average and be able to keep raising one’s standard as rivals raise theirs. (Note that to be a world champion runner it is not necessary to run as fast as is humanly possible, merely to run faster than all the others who choose to compete at that time.) Indeed, if decision makers try to cope in the face of problems of information and knowledge by applying simple ‘rules of thumb’ or following conventions so long as these deliver acceptable outcomes, they might even do better in some situations than they would if they tried to address a problem by unravelling it in all its complexity. If the decision-making environment is changing rapidly, a business that can take adequate decisions quickly might outperform businesses that spend a lot of time gathering information and arguing over the best course of action to take, for by the time the latter have worked out the ideal course of action, the situation will have changed.
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1.4.2 Factors that generate problems of information and knowledge Arguments amongst economists about whether to assume optimization/global rationality or satisficing/bounded rationality are essentially about how to do economics best/get by in doing economics, given the complexity of the subject matter. (Note the irony here in relation to the mainstream position!) The mainstream perspective keeps economic analysis relatively simple by assuming that most of the time the situations that decision makers face are straightforward enough to be seen as if they are well defined. The heterodox perspective takes seriously real world complications such as: ◆
uncertainty about the timing and extent of technical progress in the future;
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the sheer variety of products available;
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uncertainty about which technology will become the dominant system;
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exchange rate uncertainty;
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uncertainty about government policy, actions of terrorists, lobby groups, etc.;
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the need to make predictions about the actions of competitors whose pricing or capacity expansion choices will affect the profitability of the firm’s market;
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the need to predict the reliability, loyalty and pricing of supply-chain participants, whose behaviour will affect a firm’s costs and sales;
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problems in predicting the climate, earthquakes and other states of nature, and discoveries of stocks of natural resources;
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uncertainty about the direction and timing of changes in fashion;
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uncertainty about how fast consumers and employees can learn;
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uncertainty about how much should be spent on advertising and on research and development, given that the payoffs to these areas are inherently hard to assess;
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uncertainty faced by workers regarding how hard is it necessary to work to keep one’s job or win promotion;
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quality uncertainty: the problem of judging if one is being sold a ‘lemon’;
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the principal–agent problem, of knowing whether someone acting as agent is doing what they have been asked to do/acting in the interest of the person for whom they are acting;
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uncertainty about relative prices and the future rate of inflation;
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uncertainty about where the good deals are to be found in terms of price right now;
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uncertainty about the confidence of other firms and consumers and hence their willingness to spend.
This is a formidable list, and as this book unfolds you will see that it accounts for many kinds of economic behaviour and modes of organization that are prone to be neglected in purely mainstream approaches to economics. Indeed, in his 1984 book The Emergent Firm, economics professor Neil Kay has gone so far as to suggest that very little is left of the firm if we strip away functions of firms that would not be needed in a world with no information and knowledge problems. Out go: ◆
marketing;
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finance (accounting information systems, auditing, etc.);
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research and development;
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all workers except for direct labour;
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any differences between workers in terms of their skills and experience;
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internal organizational structures;
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head office, except for the entrepreneur who hires factors of production and decides what to produce, how to produce it and what price to charge for it;
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all non-profit maximizing behaviour.
All that remains is the entrepreneur, capital and homogeneous labour – which are the elements of traditional approaches to production theory (see Chapter 5). Kay, by contrast, prefers not to lose touch with reality and asks his readers to accept his suggestion that: ‘Economics is about the role of information in resource allocation. All economic problems are reducible to problems of information. In the absence of information problems there is no economic problem.’ (Kay, 1984: 1)
1.5 Summary This chapter is an important foundation stone for the material we will be covering in the rest of the book. A central concept is the idea that all choices can be seen in terms of their opportunity costs. Another central concept that we will reiterate throughout the chapters that follow is that human decision makers are boundedly rational. Very often we will begin a chapter by looking at problems as if bounded rationality was not an issue, but then we will modify our analysis to see what impact the introduction of problems of information and knowledge have on our understanding of the topics under discussion.
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1.6 Some questions to consider 1. Examine the resource allocation problems faced by senior managers in the police service. What kinds of choices do they have to make, and what aspects of the police ‘business’ make these decisions difficult to take? (As part of preparing for this, you might find it useful to watch a television programme such as The Bill and reflect on the economic aspects of the drama.) 2. Economists formally define ‘opportunity costs’ in subjective terms, as the next best thing a person imagined doing if they couldn’t do what they actually did. This makes them difficult to observe. Even so, economists may be able to help people take better decisions by advising them on what their opportunity costs might be. If someone asked you for advice on how to work out the ‘cost’ of owning/running a particular car, what advice would you give? How would your advice differ if you were giving it to people of different ages? 3. Explain how you would make use of the opportunity cost concept in the following contexts, and as you do so note what makes it difficult to assess the relevant opportunity costs: (a) As a manager considering how to deal with underperforming staff and when considering what to do when key personnel announce their intention to resign after being offered a better deal elsewhere. (b) As a marketing manager designing a marketing strategy. (c) As a homeowner trying to decide whether to do a kitchen upgrade and install double-glazing. (d) As a health service administrator advising a new Minister of Health on the essence of resource allocation problems in the healthcare area.
1.7 Recommended additional reading sources The limitations of the ‘survival of the fittest’ justification for assuming optimizing behaviour were originally explored in Armen A. Alchian (1950) ‘Uncertainty, evolution and economic theory’, Journal of Political Economy, 57, pp. 211–21. The strange story of how Alchian’s article was used to justify the mainstream perspective instead is told in Neil M. Kay (1995) ‘Alchian and “the Alchian thesis”’, Journal of Economic Methodology, 2(2), December, pp. 281–6. Kay’s paper is a warning about the need to check original sources rather than relying upon secondhand information.
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1.7 RECOMMENDED ADDITIONAL READING SOURCES
For a perceptive and very readable examination of the importance of problems of information and knowledge in the economics of industrial organization, see Neil M. Kay (1984) The Emergent Firm, London, Macmillan. The chapter ‘Entrepreneurial Salome’ is particularly recommended at this stage. If you are also studying marketing then you may find it interesting to take a look at John O’Shaughnessy (1984) Competitive Marketing: A Strategic Approach, Boston, MA, Allen & Unwin. It is a thoughtful, frank account of why marketing is (like business economics) a subtle subject with no easy answers, in contrast to the impression given by better-known texts.
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2 Markets and models Learning outcomes If you study this chapter carefully, it may help you to understand: ◆
why resource allocation sometimes takes place inside organizations and sometimes involves interaction between organizations (and individuals) in markets
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what is meant by ‘comparative advantage’ and how it leads people and firms to specialize
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what is meant by economic co-ordination and why specialization can lead to co-ordination problems
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how the ‘invisible hand’ of the price mechanism guides the allocation of resources
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what is meant by an ‘economic model’
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the difference between a ‘(force-)field’ view of the economy and a ‘complex systems’ view
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what is meant by a ‘market’, the social role that markets play and why government regulation of markets is sometimes necessary
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why firms exist.
To the extent that you develop such understanding, you should be better able to engage in discussions about: ◆
the assumptions used in economic models
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the need for state intervention in markets and the benefits of market deregulation.
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2.1 Introduction As you know, this is primarily a book about the economics of setting up and running a firm, but before we can proceed with our analysis in subsequent chapters we need to solve a puzzle: ‘Given that setting up and running a business is a process fraught with difficulties, why do people with ideas for making money bother to set up firms to put those ideas into practice?’ Most of us avoid the difficulties of building a firm by working for a business or organization that someone else has set up. People with ideas for profit-making ventures can, and sometimes do, sell them to other people or to other businesses. Many firms are started by people ‘jumping ship’ from their employers and trying to capture rewards from their ability to see profit opportunities; they can use their experience as a basis for creating their businesses and may even turn into major competitors of their former employers. But despite the scope for doing this, much new business activity results from people employed within established businesses having ideas that are then implemented by those businesses. In the latter cases, the firms may grow but those who had the ideas may not receive any particular reward except, perhaps, promotion: for them, thinking of how the firm that employs them might expand its scope may be one of the things they are paid to do as, say, ‘business strategists’. To understand how business ideas get put into practice and why new firms get set up, it is necessary to recognize that firms operate in the context of markets and involve an alternative way of allocating resources to that provided in markets. Inside a firm, a hierarchy of managers allocates resources by asking/requesting/ordering more junior managers and other employees to perform particular tasks in conjunction with particular items of equipment and goods and services purchased from other businesses. Though many of these requests are nowadays given by internal memos and via email, this method of determining how resources are used is essentially a voice mechanism in which instructions flowing down the hierarchy from person to person are the outcome of a process of planning how the resources should be used. In a market, by contrast, it is how buyers and sellers respond to changing patterns of relative prices that determines who ends up using resources and the purposes for which they get used. Hence economists typically speak of the price mechanism when discussing how markets work. The dividing line between firms and markets and voice and price mechanisms for allocating resources is actually a bit fuzzier than this. For example, when consumers complain in an effort to improve the deal they get, we have the voice mechanism working in a market; in such a situation they are not simply taking
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their money elsewhere to get better value. Markets also exist, to a degree, inside organizations, as when different branches of a multinational corporation bid against each other to supply another branch of the firm with a particular input. Recognition that the price mechanism can be used instead of the voice mechanism for allocating resources leads to a variation on our opening question: ‘Even if people with ideas for ways of making money don’t simply sell them to others, why do they bother to create firms as vehicles for getting them implemented rather than seeking to get this done by doing deals in markets?’ After all, if they adopt the latter approach they avoid having to pay managers for allocating resources. With some products, such as bicycles and Windows-based personal computers, what actually happens is rather close to the market situation: many bicycle and PC manufacturers don’t really manufacture most of what they sell. Instead, they assemble components bought from firms that specialize in making hard disk drives, motherboards, pedals, tyres and so on. A typical bicycle firm nowadays makes only the frames of its bicycles, while many PC makers even buy their equivalent of a frame – the computer’s casing – from another business. In many other product areas, resource allocation involves a much bigger role for managers relative to the market: for example, Rupert Murdoch’s News Corporation controls a vast web of print and electronic media companies, film studios and so on. Indeed, the growing reach of Murdoch’s empire and other gigantic firms, whose turnovers exceed those of many national economies, suggests that the benefits of non-market systems of resource allocation can be considerable in some contexts. We will be addressing the question of why businesses take such different forms much later in this book, during Chapters 9 and 10. But we need to understand the nature of markets in terms of what they are, how they work, and limits on how well they work, right now, and not merely to answer the question with which this chapter began. Otherwise, it will be difficult in Chapter 3 to get to grips with what economists have had to say about entrepreneurs, the people who start and shape businesses. The present chapter thus explores these questions. In doing so, it uncovers some major differences between the ways that the different brands of economics view markets. For this reason, it seems a good place to explore the general nature of economic model building, using the modelling of markets as a case study of how economists can end up with very different models of a particular feature of the world in which we live. First, though, we consider a point that is shared by economists in general, the idea that markets come into existence because people see gains from specializing in what they do and then trading with each other.
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2.2 Specialization The person in the street may have no training in economic theory but often has good economic intuition, as with the idea that ‘you can’t have your cake and eat it’. Another example of this economic intuition is the maxim: ‘If you need to get something special done, call in a specialist.’ This familiar piece of advice is consistent with the economist’s notion of ‘comparative advantage’, which is in turn an application of the idea of opportunity cost. However, the person in the street may often be thinking in terms of what the economist would call ‘absolute advantage’ when discussing why differences in skills mean that it makes sense to specialize and engage in trade. It is vital that you take the time to see the difference here, for without an appreciation of it there will be difficulty in understanding why a person, or a firm, that is better than other parties at doing a multitude of things may still find that it makes sense to specialize and trade with the others. First, we will illustrate the concept of absolute advantage. Suppose that an accountant can unblock a drain in four hours and do the accounts of a plumber in two hours, and a plumber can unblock a drain in one hour but takes three hours to do her accounts. If so, it will probably pay for them both to stick to their respective professions. By not taking up time unblocking his drain, the accountant can do the accounts of two plumbers, and a plumber can unblock three drains in the time freed up by getting an accountant in to do her accounts. If they do not specialize, then in four hours’ time the accountant will have just finished unblocking his drain and the plumber will have unblocked one drain as well as having done her accounts. If they specialize, then in four hours the accountant can complete a second accounting task and the plumber can unblock four drains. The gain from trade and specialization is thus the ability to produce in the four hours one extra lot of accounting services and two more unblocked drains. The economist’s more sophisticated ‘comparative advantage’ basis for specialization focuses not on absolute differences in ability to undertake a particular task, but relative differences in ability to perform different tasks. To illustrate this, let us change the numbers in the example such that the plumber is better than the accountant at both unblocking drains and doing accounts. The accountant’s situation is as before, but now the plumber can unblock drains in one hour and do accounts in an hour and a half. If they both continue to specialize in their respective trades, then in four hours’ time the plumber will have unblocked four drains and the accountant will have completed two accounting tasks. If they do not trade with each other, then in four hours’ time the accountant will have just finished unblocking his drain and the plumber will have done her accounts but
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only be halfway through unblocking a third drain. Failure to specialize reduces output in the four-hour period by half an unblocked drain and one accounting task. In short, if everyone specializes in the things they are relatively good at doing and then exchanges the output for things that other specialists have produced, everyone could be better off than if they operated as generalists. The comparative advantage story of the gains from trade is based on several major assumptions: ◆
There is full employment – in other words, there is sufficient demand for the services of both the plumber and the accountant to keep them both working as specialists for as long as they wish each week.
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Relative capabilities are fixed. In practice, relative capabilities can be changed via education, having more practice and so on. Just imagine what would have happened if Japanese business had continued to specialize where it had a comparative advantage a century ago, rather than setting out to learn how to make advanced industrial products that it could have imported from Europe and the USA. In the short run, Japanese attempts to make such products came at the cost of poor productivity and low quality (as the comparative advantage analysis would lead us to expect), but in the long run Japanese firms were able to match or get ahead of those in the West.
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People will always attempt to make the most of potential gains from trade. Sometimes, however, they may have reasons for foregoing such gains. For example, they may derive a sense of achievement from doing a particular task themselves, not merely from the end result – ‘It took me ages, but, hey, I did it!’ – and in a world of change may recognize the strategic advantages of being multi-skilled, of not ‘putting all their eggs in the one basket’.
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There are no evaluation costs or monitoring costs – in other words, no costs of making sure that the specialist is able to do the job and actually does do it. The numbers in these kinds of examples would look very different if customers found it necessary to take time to give the specialist access to the relevant site or documents and then had to keep an eye on the specialist to make sure the work got done.
To the extent these assumptions seem unrealistic, we may wonder how far the comparative advantage analysis of specialization is giving us the right answer for the wrong reasons. But, even if we do that, there is no getting away from the fact that many people and businesses do choose to specialize rather than try to be self-sufficient in all areas where they need to get things done.
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2.3 Scope for failures in economic co-ordination Specialization brings potential for people to be better off than if they adopt a ‘doit-yourself’ approach to life. However, because it involves social interaction in the presence of problems of information and knowledge, it also brings the risk of co-ordination failures such as the following: ◆
Buyers cannot find what they want, when they want it, at a price they are prepared to pay, even though this price is greater than or equal to the cost to society of producing it.
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Communication failures lead to the delivery of the wrong goods, or of system components that do not fit together.
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Breakdown or late delivery in the supply chain disrupts the flow of production elsewhere.
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There are so many suppliers in a market that ‘normal’ rates of return cannot be achieved.
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Uncertainty about product standards leads buyers to hold back until an industry standard is established.
◆
Organizations fail to improve their operations due to failures in feedback mechanisms, as in cases where customers simply stop buying and take their business elsewhere, rather than voicing complaints about particular shortcomings of the firm in terms of price or product standards.
A self-sufficient individual living as a recluse does not have to worry about the problems just listed. By contrast, craft workers, who produce things from start to finish, have to worry about selling their output to someone else – but otherwise they can ‘be their own boss’ and not have to worry about fitting in with others. The craft worker can perform some stages in a production process in a leisurely manner on some days but not others, or not work at all some days and work long hours on other days, as he or she chooses; there is no need to keep an eye on the clock and the pace of production. The co-ordination issue impinges much more on the lives of employees working in a factory. They cannot work effectively if others do not provide inputs of particular goods and services at the right time, and if they fail to perform as their managers expect, then other employees further down the production line will be unable to perform their own roles in the production chain. Clocking on and keeping an eye on the clock and output requirements made life much more stressful for workers in the factory systems that emerged in the Industrial Revolution, but without such discipline and a steady work pace,
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production costs would have been much higher, with higher inventories needing to be carried as buffers to enable production to keep going when some workers were running behind or were absent. Figures 2.1 and 2.2 (inspired by Axel Leijonhufvud, 1986) may help clarify the significance of specialization for the management of supply. In both cases, production entails four stages and four workers. In Figure 2.1, each worker makes the entire product, but paces the production process differently; different workers may opt to work very different working hours. In Figure 2.2, by contrast, each worker performs only one of the stages, according to who can perform which task most efficiently: Dick just does cutting, Tina just does machining, Harry just does polishing and Sue just does painting. For all the workers to be fully employed, they must be able to pass their output on to the next worker just when it is finished and at the same time receive the inputs on which they need to work.
Sue Tina Harry
Cutting
Machining
Cutting
Machining
Cutting
Dick
Polishing Polishing
Machining
Cutting
Painting
Polishing
Machining
Painting
Painting
Polishing
Painting
Time
Figure 2.1 Crafts production
Dick
Tina
Harry
Sue
Cutting
Machining
Polishing
Painting
Cutting
Machining
Polishing
Painting
Cutting
Machining
Polishing
Painting
Cutting
Machining
Polishing
Time
Figure 2.2 Factory production
Painting
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Clearly, a factory in which people did as they wished, when they wished, could be completely chaotic. But at least if the factory were quite compact, each worker might get some sense of the consequences of his or her actions for the performance of the enterprise as a whole. They would also be able to communicate readily with each other and work out ways of co-operating to achieve mutually beneficial outcomes. Within a larger business, the co-ordination problem tends to be resolved more by a hierarchical management system in which managers (planners) tell workers (doers) what needs to be done. Being a member of a sizable organization in the long term means being generally willing to do what the boss asks. To the extent that workers forego the chance to be their own boss and accede to someone else’s demands they must be enjoying some benefit associated with the improved co-ordination that bosses bring, despite the bosses absorbing some of the value that the organization generates. In an important sense, the boss is rather like the coach of a sporting team – someone who enables the players/workers to achieve more than they could on their own and hence to be better rewarded. If co-ordination problems are lessened in organizations largely by co-operation and managerial direction, how are they kept in check in the economy at large, where modern products may consist of hundreds or thousands of components made by specialized suppliers and possibly sourced from all over the globe? Here, the perspectives of mainstream economists and their rivals are strikingly different. In essence, the mainstream approach focuses on impersonal ‘forces of supply and demand’, mediated by ‘price signals’, and sees the economic system in terms of analogies from physics. By contrast, heterodox approaches focus also on the role played by relationships and social institutions and have a vision that, if it resembles any of the physical sciences, looks rather more like chemistry or ecology.
2.4 Market-based co-ordination via the price
mechanism For mainstream economists, the answer to the co-ordination question is to be found by understanding how markets work. The fact that co-ordination problems are far less acute than they have the potential to be makes it appear as if the actions of over six billion people around the world who buy and sell different combinations of goods and services are being guided by some kind of ‘invisible hand’. But what is really going on is that they are simply responding to, and affecting, the pattern of relative prices in a large number of markets.
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2.4.1 The mainstream view of ‘a market’ The standard definition of a market is a place where buyers and sellers of goods and services meet in order to trade with each other. Note that this definition interprets the word ‘place’ in a very general way. It does not necessarily refer to a specific or identifiable geographical location. The most obvious examples of this lack of geographical location are provided by the virtual markets for a variety of goods and services located on the Internet. If you order a book from Amazon.com you will conduct your trade in a market located in ‘cyberspace’. 2.4.2 How markets work How does a market work? This short question has a long answer, so we will develop it gradually. A market for a specific good or service can be thought of as consisting of two sides. On the one side of the market are people we will call buyers or consumers who have wants or needs. Some of these will be procurement officers of firms and other organizations who need to obtain goods and services used in the production of other goods and services. On the other side of the market are people who we will call suppliers who offer goods and services for sale. When the goods and services offered for sale by suppliers coincide with the wants and needs of consumers the two sides will wish to trade with each other. Trading involves an exchange between the members of each side. Purchasers give the suppliers a money payment in return for taking over ownership and custody of the particular good or service being traded. To help with our explanation we will consider in some detail the hypothetical example of buying a lunchtime hot dog from a street vendor. It may be helpful to imagine yourself in the role of the hot dog consumer. When you buy a lunchtime hot dog from a street vendor you give the vendor cash and, in return, the vendor gives you ownership and custody of a hot dog. The amount of cash you give in exchange for the hot dog is called its price. (This may seem to be stating the obvious but we bring in the notion of price in this way to try to preclude confusion between price and cost. It would be incorrect, in economic terms, to say that the amount of cash handed over is the cost of the hot dog, since if you had been unable to buy the hot dog, ‘whatever else you would have done with the money’ is the opportunity cost of the hot dog. You might have bought something else, or decided to forego lunch altogether and hang on to your money for the moment. The best alternative is the ‘opportunity
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cost’ of the hot dog to you.) The price you will pay for the hot dog depends upon a number of factors. If we assume that you are happy with the quality of the hot dogs being offered for sale (maybe because you have purchased one from this vendor before, or a friend has recommended her to you, or the vendor has let you taste a sample), then, from your perspective as a potential consumer, one of the prime considerations for buying a hot dog will be whether it is worth the vendor’s asking price. In other words, does the hot dog represent good value for money to you? In order to decide whether or not something is good value for money you can ask yourself the question, ‘What is the highest amount I am prepared to pay for this good or service?’ So, if you are prepared to pay a maximum of £3.00 for the hot dog but the vendor is selling the hot dog for less than this, say £2.50, then it represents good value for money to you and you will be willing to buy it. Note, however, that when the hot dog vendor set the asking price she had no idea that you would have been willing to pay up to £3.00 for the hot dog. The valuation you have formed in your head is said to be subjective because it is based upon your own feelings, tastes and opinions (see Chapter 4 for a more extensive discussion of tastes). It is reasonable to assume that you are not the only hungry person at lunchtime, so the hot dog vendor might expect to serve more than one customer. Other potential consumers will be asking themselves the same subjective valuefor-money question that you have asked yourself, but because we are all different from each other some of these potential consumers may place a lower value on the hot dog than the asking price and, as a result, they will choose not to buy from the vendor. On the other hand, others may share your valuation of the vendor’s wares or even value them more highly and so choose to purchase a hot dog for lunch at a price of £2.50. The problem for the hot dog vendor is to set an asking price that allows her to attract a sufficient number of consumers to make being in the hot dog business worthwhile. Given that the hot dog vendor cannot have direct access to the subjective valuations of potential consumers she can only arrive at a suitable asking price by a process of trial-and-error price setting in the market. For example, if she sets a price that is too high, sales will be low and the vendor will have to reduce her price in the hope of attracting more consumers to her stand. Alternatively, if the vendor finds herself swamped by orders and is unable to provide every consumer who wants one with a hot dog, the asking price may be too low. In this case an increase in the asking price should lead to some of the consumers deciding not to have a hot dog for lunch.
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Summary so far: ◆
When setting asking prices the vendor responds to a signal from the market.
◆
The signal to which the vendor responds is the number of units sold.
◆
The number of units sold reflects the collective decisions of consumers about whether or not to purchase hot dogs at the current asking price.
◆
Each individual consumer bases their own decision upon a comparison between their subjective valuation of the hot dog and the actual current asking price.
You should note here that the vendor acts upon observable data, namely, the number of units sold. While it would be nice to know precisely what subjective value each potential consumer places upon the hot dogs being offered, the collection of such data would be extremely time consuming. It may also be impossible, for the simple reason that potential consumers may be unwilling to reveal this data directly or honestly. We can conclude, therefore, that the collective data fed back from the market to the vendor is a very important source of information. Obtaining reliable information is crucial to the success of any business because without it decisions are very hard to make. Our explanation of prices up to this point has been kept relatively simple by the implicit assumption that you, and other potential consumers, go to the same vendor when you want a hot dog lunch. If we include now the possibility that the hot dog vendor has several rivals who sell hot dogs of similar quality it means that the potential consumers of lunchtime hot dogs will have a choice of vendors. In this case, in order to get the best deal on a hot dog, the sensible consumer will search through the vendors in the local area in order to find the lowest asking price. The consumer will then compare the lowest asking price to his or her subjective valuation of a hot dog and choose whether or not to make a purchase. At this point you may well be thinking that the addition of rival vendors to the story makes the original vendor’s pricing problem a little more complex and, to a certain extent, you are correct. This is because now the original vendor may lose sales to lower-priced rivals, even if her asking price is less than the subjective valuation of hot dogs held by a significant number of potential consumers. For example, if your own search reveals a rival who is asking £2.00 for a hot dog of equal quality to your original vendor (whom you will recall is asking £2.50), you would be sensible to buy your lunch from the rival’s stand because you will save money. Does this wider choice for consumers change the basic way the original vendor makes use of the market to obtain information about the price consumers are willing to pay for her hot dogs? The answer is ‘no’, because the vendor can
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still use a process of trial-and-error pricing and respond to the number of units she actually sells at a particular price by adjusting the asking price downwards in order to sell more hot dogs, or upwards in order to sell less. There is no reason to change this trial-and-error approach even in this more complicated market that contains rival vendors. In other words, the market signal (the number of units sold at a particular price) is as useful in a world with rivals as it is in a world without rivals. Put another way, the market is like a scientist’s laboratory, because every exchange with consumers can be thought of as part of a process of discovery that will give rise to new data. If you compare this story to your own fast-food buying experiences you will probably be puzzled by the fact that price changes you have observed in the fastfood outlets in your local area occur relatively infrequently. So, how can we reconcile the story of apparently continual price adjustment being told here with the facts as we know them from our observations of the real world? Put slightly differently: does the process of price adjustment by individual vendors mean that consumers will face continually changing hot dog prices and therefore have to keep buying their lunch from different vendors every day or will the going price for a hot dog settle down to a stable level? In order to help us arrive at an answer to this question we will construct a model of the hypothetical hot dog market to see where the process of trial-and-error adjustment of prices leads us. A model is nothing more than a simplified description of something, an approximation to the more complex aspect of the world it represents. The model that we construct attempts to present a simple picture of how mainstream economists would see this sort of market. As you work through the explanation of the model outlined in Section 2.5 below you will probably want to ask several questions because of the assumptions we have made. This is good – we would encourage you to develop a critical approach to things that you read – but do not let your questions stop you reading through to the end of the section. Instead, note your questions down and compare them with our discussion of the model in Section 2.6.
2.5 A mainstream model of the hot dog market We will keep things simple by making the following assumptions: (i) There are four hot dog vendors, who we will label V1, V2, V3 and V4, who compete with each other for business in the local area. Each vendor supplies an identical hot dog to its rivals.
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(ii) The cost to each vendor of making a hot dog is £1.50. (iii) There are 14 potential customers in the local area. We will identify each customer by assigning him or her a letter, A through to N. Each customer’s subjective value of a hot dog is listed in Table 2.1. Note that the hot dog vendors do not have direct access to the information contained in Table 2.1. (iv) Trade takes place on a daily basis and each vendor decides on the current day’s asking price in response to the number of units sold on the previous day. (v) Each consumer searches his or her local area thoroughly every day and buys a hot dog from the vendor who has the lowest asking price on the day, but only if this asking price is less than or equal to their subjective valuation. If two or more dealers share the lowest asking price consumers will be shared equally between them. We can use this model to analyse typical decisions that each vendor will make on each day of trading. Day 1 To get things started we will let each vendor set an asking price that is arbitrary because they currently have no information about the market upon which to act. Let us say the following asking prices per hot dog are posted: V1 = £2.20; V2 = £2.30; V3 = £1.90; V4 = £2.00 Table 2.1 Consumers’ subjective evaluations of a hot dog Consumer
Subjective value (£)
A
2.60
B
2.50
C
2.40
D
2.30
E
2.20
F
2.10
G
2.00
H
1.90
I
1.80
J
1.70
K
1.60
L
1.50
M N
1.40 1.30
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When the consumers search for their lunchtime hot dogs they will discover that vendor V3 has the lowest asking price. Given the distribution of subjective values in Table 2.1 we will expect customers A through to H to purchase a hot dog from V3. Customers I through to N will not buy a hot dog. Vendors V1, V2 and V4 will not sell any hot dogs. Day 2 Clearly vendors V1, V2 and V4 will set a different asking price today in an attempt to attract some customers. V3 has no real need to set a different price although she could lower her price in order to try to increase the number of consumers visiting her stand. Also, V3 will probably have talked with her customers and found out that V1, V2 and V4 were charging higher prices yesterday and are therefore likely to reduce prices today. Similarly, V1, V2 and V4 may well have learned what price V3 was charging yesterday and will take this as a starting point for their decision today. Note that there is no unique answer to the pricing problem for each vendor at this stage so let us see what happens when each charges the following prices: V1 = £1.70; V2 = £1.60; V3 = £1.80; V4 = £1.50 When consumers search the local area today they will discover that V4 has the lowest asking price, so V1, V2 and V3 will sell no hot dogs. V4 is asking a price that attracts customers A through L, so he will sell 12 hot dogs. Day 3 V1, V2 and V3 will have to reduce their asking prices today if they wish to sell some hot dogs. V4, however, will be quite happy with a price of £1.50 even though a further price cut will probably tempt more consumers to buy a hot dog. You should note, however, that V4 has no incentive to carry out a further price cut, because if he did this every hot dog would be sold at a loss. If we assume that V1, V2 and V3 have somehow discovered the price being charged by V4 yesterday they will be able to work out that their only choice now is to ask a price of £1.50 also. Just like V4, none of the others has an incentive to reduce prices below £1.50 because nobody wants to sell hot dogs at a loss. Today then, V1 = V2 = V3 = V4 = £1.50. At a price of £1.50 each firm takes an equal share of the market (three consumers each) and none of them has an incentive to adjust their prices up or down in the days that follow. A price reduction by any vendor will lead to losses while price increases will lead to zero sales. The process of market competition has given rise to a stable market price.
2.6 Further discussion of the hot dog model We have just introduced you to your first economic model. Business economists use many models to help them understand things better so it is important that you learn how to use models properly too. Many people find this aspect of business
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economics difficult to understand, but our discussions with students over the years have revealed to us that this is mainly because they find it very hard to believe that an ‘unrealistic’ model can provide us with meaningful insights about the real world of business. This problem arises because when we look at the world around us we see that it is a fairly complicated place and this leads some people to ask, ‘Shouldn’t economists’ models describe this world in detail?’ Let’s use the hot dog model to explore this question. The claim we have made for our hot dog model is that it illustrates how interactions between consumers and suppliers in a market will give rise to a stable price. We have arrived at this conclusion by telling a very simple story devoid of intricate details. For example, we have: ◆
labelled consumers with letters from the alphabet rather than identified them with real people who have particular names and particular jobs or careers;
◆
failed to name the hot dog vendors and provided no details about their reasons for being in the hot dog business;
◆
not stated which town or city the consumers and vendors live in.
Ask yourself, ‘Would the inclusion of these details make the story about how a stable price came about more believable?’ The answer is ‘No’; the inclusion of these descriptive details would add nothing useful to our analysis, in fact they would probably clutter it up and make it more difficult to concentrate on the issue under investigation. When building models the skill you must master is to include only those details about the problem under investigation that are relevant. Put another way, if you build a model of something, you should look at it when you have finished and ask if you could cut away any element of the model without destroying the essence of the story you are telling. This practice is known as applying Ockham’s razor (also called Occam’s razor) after a fourteenth-century English philosopher called William of Ockham. Ockham stated that if it is not necessary to introduce complexities into arguments then you should not do so. In other words, Ockham’s razor is a logical tool to help you cut the fat from your models and arguments. This means that we should not seek to build models that are realistic in the sense that they are full descriptions of the real world, but instead we should try to build models that capture the relevant features of the real world. This brings us to a discussion about the role of simplifying assumptions in our models. When we built the model of the hot dog market we listed several assumptions that helped us to define the model. In particular we made assumptions about
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how the human actors (the consumers and the suppliers) in the model would behave. Recall that the actors in the model spend time and effort gathering information and base their decisions about what to do upon this information. Given that we have built the model to provide us with some insights into the consequences of interactions between real world consumers and real world suppliers in real world markets, we must ask ourselves if the assumptions we have made are sensible. We discuss the particular assumptions of our hypothetical hot dog market in greater detail below, but you should bear in mind that the single most important test of relevance for our model is whether the modelled human beings are behaving in a manner that is consistent with what we know about the characteristics of real human beings. The other assumptions such as the cost of producing a hot dog, the number of consumers in the market and the number of hot dog vendors are important too, but only because they help to explain the features of the environment within which the modelled actors make their decisions. Clearly, the results of the model we have built and the conclusions we derive from it will depend crucially upon the assumptions we have made, so if we find that some of the assumptions are not very sensible we may well be right to worry about the usefulness and relevance of the model. This point is very important more generally because business economics is a normative subject. This means that we study business economics in order to work out how we should act when we manage businesses of our own, or when we offer consulting advice to other business managers. So, if we have based our understanding of how a market works on a model of a market which has questionable relevance to a real world market of interest then any action we take when we use this particular real world market, or advice we offer to others when they use this real world market, is likely to be badly flawed. You should note that when you use a model to help you understand some aspect of the real world you are said to be applying it, and it is highly unlikely that a single model can be applied to all real world cases. For example, we are not claiming that our simple model of the hot dog market can be applied to the market for motorcycles in the UK, although it may provide us with a useful starting point. In different applications you will almost certainly have to modify a basic version of the model to make it more relevant to the specific case you are looking at. Don’t worry – we’ll be giving you plenty of examples and practise at applying models as you work through the book. Let’s examine the assumptions of the hot dog market model in turn to see if they seem to be sensible. We will start with assumption (v) because it describes
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how the consumers in the model behave and then we will work through the other assumptions in reverse order. Assumption (v) states that consumers search their local area on a daily basis in order to find out which of the hot dog vendors has the lowest price. The first question we might ask here is why consumers are searching their local area. The answer is to get hold of information so that they can make a decision. A possible alternative to this assumption could be to state that consumers are simply given this information. This would seem to be an unreasonable assumption to make in the context of the hot dog market because it would mean we have to either add another actor to our story (someone who spends their time giving out information) or, alternatively, postulate that human beings have some kind of all-seeing psychic connection to the vendors and, as a result, receive automatic updates of their respective asking prices. So, the statement that consumers search for suitable information seems to make sense. However, we have provided no details about how these consumers make their searches. Do they walk to each vendor in turn, take a bus, look up the information on a suitable website, ask their friends, or phone the vendors? It does not really matter which of these methods is used for the purposes of our example here because we are building a model to examine the consequences of search behaviour, not the actual detail of the search behaviour itself. It would only matter if we were building a model to explore the implications of different kinds of consumer search behaviour. We will be doing this in a later chapter, but here we can apply Ockham’s razor to good effect. The final point to note about assumption (v) is our statement that consumers search their local area. We do not define the boundaries of this local area explicitly, nor do we need to; the statement is there to indicate that consumers do not carry out searches over a large area when they decide they would like a hot dog. For example, if you were an office worker in the centre of London and were looking for a lunchtime hot dog you would probably not devote too much time and energy to your search activity and as a result would not search the whole of London, nor would you make a 150-mile road trip to Manchester on the off chance that the asking price for a hot dog may be lower there! The general idea of locality is important because it defines the extent of consumers’ search areas and this in turn helps us to identify the boundaries of markets. We will show you later in the book how different types of goods and services have different sized localities and how some of these can be global in scale. Assumption (iv) states that trade takes place on a daily basis, with each vendor choosing the current day’s asking price based upon information revealed from
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yesterday’s market experience. This assumption introduces us explicitly to the concept of time in economic models. Taking account of the passage of time is important, because when a hot dog vendor chooses a price his action will have effects in the market that will lead to consequences for the vendor, the vendor’s rivals and consumers. These consequences will only become apparent as time passes. This means that when we examine markets it is important to ask how long it will take for the consequences of specific actions to become apparent. In the example here, we have arbitrarily decided that each vendor makes a decision on a daily basis, but we might just as easily have decided to model the market for hot dogs by assuming that each vendor makes a new pricing decision every hour. For example, if a vendor sets a price and after one hour has sold no hot dogs then this vendor may well decide to reduce the asking price at the end of this hour. In other words, the vendor may respond to the signal he has received from the market in a much shorter time period than the one we have used in our example. The other vendors may act in a similar fashion. We have predicted above that the process of competition will lead to stable prices by day 3, so what does this new story, where vendors’ decisions are made hourly, lead us to conclude? Well, the same process of price adjustment will hold true, only now the stable price of £1.50 may be reached sooner because vendors are responding more frequently to market signals. By changing assumption (iv) we do not alter the final outcome of the model and we do not change the basic story of vendors responding to signals from the market. This means that for our current purpose, which you will recall is to explain the basic elements of the market process, the units of time that define the vendors’ decision period can remain arbitrary and we can accept that assumption (iv) is reasonable. So, when we look at a real world market does taking account of the passage of time really matter? The answer to this question could only ever be ‘no’ if all we were interested in was the end result of the competitive market process described here. But this is not all that we are interested in. Real world business activity takes place in real time and it is important for us to understand that, for various reasons, not all markets in the real world reach stable prices as quickly as the hypothetical hot dog market we have been discussing here. This means that we should always try to understand the timing of the events taking place in any market, as well as understanding where the series of events is likely to take us. It is particularly important because the usual aim of people who run businesses is to make as much profit as possible and the window of opportunity they have to do this in may be only brief and occur before a situation of stable prices has come about. We will return to this issue several times in the book.
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Assumption (iii) states that there are 14 potential consumers of hot dogs. Assuming that only 14 potential consumers exist is, of course, a teacher’s technique to help make our job of explaining things to you as easy as possible. In the real world if only 14 potential consumers existed for hot dogs it is highly unlikely that anyone would bother to become a hot dog vendor! We could have stated that 14 000 potential consumers of hot dogs existed in the local area with 1000 of these sharing consumer A’s subjective value, another 1000 sharing B’s subjective value and so on, but at the end of the day we would still tell the same story about how prices converge to the stable level because the underlying principles of market adjustment discussed above would still be the same. This is not to say that the number of consumers in a market does not matter generally but, for our current purpose, we have used Ockham’s razor to trim away superfluous complexity. We have also applied Ockham’s razor judiciously to assumptions (ii) and (i) for exactly the same reasons that we have applied it to assumption (iii). We could modify assumption (ii), for example, by assuming that each vendor has a different cost of production from its rivals, or we could have assumed that a vendor who sells more than two hot dogs enjoys some cost savings on production of the third and fourth hot dogs and above. Alternatively we could have assumed that each firm produces a given number of hot dogs at the start of the day and any that remain unsold have to be stored until the following day at some cost. We could modify assumption (i), for example, by assuming there are more than four vendors, or we could assume that new vendors enter the industry on day 2, or that one vendor offers a higher quality hot dog than the others. All of these modified assumptions are reasonable, but once again for our purposes they add unnecessary complications to the model. Where we might want to worry about the assumption that there are only four hot dog suppliers is if questions get asked about whether we are making any further assumptions that are not explicitly stated. For example, we have said nothing about the possibility that the hot dog sellers might collude to try to push up the market price, yet collusion might be argued to be more likely if there are only a few suppliers who need to get together to work out a joint strategy and keep an eye on each other to ensure it is followed. So perhaps we have been implicitly assuming that collusion is illegal (as it normally is) and the hot dog vendors are all law-abiding. Other charges that we have been making implicit assumptions might also be raised. If one vendor were wealthier than the others, she might have the resources to drive the others out of the market by setting a price below £1.50. The others might take a while to go (to know how long, we would need to introduce assumptions
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about their expectations regarding the duration of this vendor’s strategy, their wealth and opportunity costs). Even so, such a predatory pricing strategy might be worthwhile if the subsequent increase in profits exceeded the value of wealth sacrificed whilst selling hot dogs below their production cost. Perhaps we are implicitly assuming that the four vendors have equal wealth, or that predatory pricing is illegal, as it often is (cf. the battle between Virgin Atlantic and British Airways), or that ethical concerns get in the way of such behaviour. In this section we have discussed the model of our hypothetical hot dog market in some detail and we have shown that competition between hot dog vendors for the patronage of consumers leads to the emergence of a stable price. Economists usually refer to this stable price as the equilibrium market price to reflect the notion that once it has been reached it will not change unless the specification of the market changes in some way. An equilibrium market price is obtained when the process of competition between suppliers leads to a situation where nobody has an incentive to change their current behaviour. As you saw, at a price of £1.50 none of the hot dog suppliers has an incentive to cut prices any further because each hot dog costs them £1.50 to produce. Likewise, none of the hot dog suppliers has an incentive to increase their asking price above the equilibrium price because consumers will not buy a hot dog from a more expensive supplier when alternative suppliers are offering hot dogs for sale at lower asking prices. We hope you will agree that the story we have told about price adjustment in the hot dog market makes sense and does not seem excessively unrealistic. We have populated the model with representative human actors who make decisions on the basis of information they have gathered from their environment; consumers actively search for information about asking prices among rival vendors, while vendors choose asking prices as a result of previous sales figures. If you were a consumer and you wanted to buy a good or service you would also have to carry out some kind of search to discover prices being charged by rival suppliers, and if you were a vendor you would be keen to learn how sales of your product were affected by your asking price, so we can claim that our model captures important aspects of the behaviour of real consumers and real suppliers. It is still a very basic model, but its specification has been sufficient to enable us to tell a story about price movements. You have now reached the stage where you can begin to apply the lessons you have learned from the hypothetical model to real world markets. Applying economic models is not a question of following a set of predetermined easy steps; in fact, it is something of an art that requires you to exercise your judgement. That said, the more often you do it the more skilled you will become and many
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of the lessons you will learn in the following section apply equally to applying other models to which we will introduce you later in the book.
2.7 The art of applying a model To help you learn how to apply economic models we will use a mini-case study. Table 2.2 lists some real world price data. The data are for a specific model of hand-held global positioning system (GPS) – the Garmin GPS III+. These data were collected from various UK-based Internet retail sites on Tuesday 14 January 2003 in an exercise that took about ten minutes to complete. Additional information of note is that the Garmin GPS III+ is a navigational aid that had been available for well over two years at this date. It has been the subject of detailed consumer reports and has always been favourably reviewed, which has helped it to become a very popular product; it is now a well-established instrument with a variety of outdoor enthusiasts including hikers, mountaineers, mountain bikers, yachtspeople, paraglider pilots, skiers, rally drivers and the like. A comprehensive list of monthly magazine publications exists to offer advice and inform these leisure pursuits. A more advanced GPS, the Garmin GPS V, has been introduced recently. This instrument features a number of significant enhancements over the GPS III+ and its retail price in early 2003 reflected this, being on average almost twice that of the GPS III+. Our aim here is to see whether our economic model of the market helps us explain the prices recorded in Table 2.2. This means we are required to tell a convincing story about how retailers of the GPS III+ have arrived at their respective asking prices. We can begin building our story by simply inspecting the data and Table 2.2 Asking prices for a Garmin GPS III+, 14 January 2003 Supplier’s web address
Supplier’s asking price
www.offroadstore.co.uk
£290.23
www.gpsw.co.uk
£292.54
www.navcity.co.uk
£292.54
www.outdoorgear.co.uk
£305.95
www.askdirect.co.uk
£314.00
www.mailspeedmarine.co.uk
£334.00
www.southernmarine.co.uk
£363.32
www.expansys.com
£370.39
www.ultimatedesign.co.uk www.harwoods-yacht-chandlers.co.uk
£390.00 £429.95
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making a rather obvious, but nevertheless important, observation: the market for the GPS III+ does not appear to have achieved an equilibrium price. Does this mean that our understanding of how markets work that we developed earlier is wrong and should be ignored? To help us address this question let’s review the facts as we know them: (i) Asking prices vary between a lowest price of £290.23 and a highest price of £429.95. The lowest asking price is only two-thirds of the highest asking price. (ii) The comparative price information collected in Table 2.2 can be obtained quickly and easily by anybody who has access to the Internet. (iii) The GPS III+ has been available for over two years so we might reasonably assume that the market is well established. Furthermore the product has been reviewed favourably in a multitude of leisure magazines. (iv) A superior model, the GPS V, has been introduced recently. Clearly, we are going to have to take account of these facts if we are to construct a believable story – that is, an explanation in which we can have confidence. One interpretation of fact (i), the large difference in asking prices for the GPS III+, is that consumers are failing to provide a competitive environment for suppliers, due to factors such as the following: ◆
Buyers are not behaving sensibly.
◆
Buyers are simply too lazy to search for a short time on the Internet.
◆
Buyers do not have personal access to the Internet and do not believe it to be worthwhile to use publicly-available Internet access.
◆
Buyers do not search via the Internet because they do not have the computer skills required.
If many consumers were, for such reasons, poorly informed about where the best deals were to be had, some suppliers might decide that it is worth trying to charge prices well in excess of the ex-factory price that they pay Garmin for stocks of the GPS III+. Such suppliers might judge that the excess profits obtained on those sales that were thereby achieved could be greater than the profits foregone by not selling to those consumers who were well informed. From this standpoint, the model does not look like one we should apply to this market. A mainstream economist might nonetheless attempt to dispute such an interpretation of the failure of a single price to emerge for the GPS III+ on the basis that information about relative prices is quite straightforward to obtain. Those who do not have access to the Internet might well have friends that do, and may
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well have an idea of what prices to expect from seeing advertisements and reviews in consumer magazines – after all, fact (iii) suggests that consumers are very well informed about the features and capabilities of the GPS III+ because leisure activities are strongly supported by magazine publications that exist primarily to inform leisure activity enthusiasts about all aspects of their chosen pursuit, including performance assessments of salient gadgets. If such a defence were in order, perhaps fact (iv) holds the key to our mystery. A new model of GPS has been launched recently and it is better in several respects to the GPS III+ albeit for a greater price. We can look at this fact from each of the two sides of the market. On the demand side, a mainstream economist might reason that if consumers of GPS gadgets are on the whole a well-informed bunch, it is reasonable to propose that when a new, improved version of a gadget becomes available they would rather purchase this than the older model if the better specification seems worth the extra outlay. On the supply side, retailers will notice sales of GPS III+ falling off, so we might expect to see them reduce their asking prices in the hope that the now reduced priced older gadget still passes the value-for-money test for a significant number of consumers. Now, if this story is true it might mean that the market for the GPS III+ was not in equilibrium when the prices listed in Table 2.2 were recorded. The price differentials between the listed retailers may therefore simply reflect that some have responded to the introduction of the GPS V more quickly than others and in the fullness of time the laggards (i.e. the higher priced retailers) may well bring their prices into line with the lower priced retailers. The latter are likely to do this if they find that they are holding unsold stocks of the GPS III+ for longer than they were expecting. From the standpoint of the model, the market for the GPS III+ would be predicted to be in equilibrium prior to the introduction of the GPS V. This is something we could test if we could obtain pricing data for several dates prior to the introduction of the GPS V, to see if there was a corresponding greater equality in prices between the retailers than that displayed in Table 2.2. The model would also lead us to expect that, after the new gadget has been on sale for a while, the prices asked for it by retailers should not display the kind of dispersion evident in Table 2.2. If significant price differentials are revealed we may have a more complicated story on our hands than we originally might have expected. What actually happens in the latter case is revealed in Table 2.3, compiled by a search on 10 May 2004. Two sites did not list the Garmin GPS V, but the results for the rest are very interesting and not particularly good news for the mainstream model.
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Table 2.3 Asking prices for a Garmin GPS V Deluxe, 10 May 2004 Supplier’s web address
Supplier’s asking price and ratio of its GPS V price to its GPS III+ price
www.offroadstore.co.uk
£399.00
1.38
www.gpsw.co.uk
£361.95
1.24
www.navcity.co.uk
£359.95
1.23
www.outdoorgear.co.uk
£442.95
1.45
www.askdirect.co.uk
£299 (’reduced from £409’) 0.95 (pre-reduction: 1.30)
www.mailspeedmarine.co.uk
Product not listed
www.southernmarine.co.uk
£433.60
1.19
www.expansys.com
£360.45
0.97
www.ultimatedesign.co.uk www.harwoods-yacht-chandlers.co.uk
Product not listed £539.95
1.25
Although no single pattern is evident, two features at least stand out when we compare Tables 2.2 and 2.3. One is that Harwoods Yacht Chandlers, the last firm listed, is the most expensive in both cases: 48 per cent more for the GPS III+ and 80 per cent more for the GPS V Deluxe compared with the cheapest quotations. It is interesting also to note that if the ASK Direct price had not been drastically marked down, the Harwoods price is 50 per cent higher than the most common price (i.e. roughly £360) – almost exactly the same margin more than on the most common price of the older product. The second thing that stands out is that four of the suppliers (of which Harwoods is one) have ratios of around 1.20–1.25 between their GPS V and GPS III+ prices. One possible interpretation of this is that these suppliers are using some kind of simple mark-up rule for pricing these products: it could well be that the price they were paying Garmin in May 2004 for the GPS V is about 20–25 per cent more than they paid for the GPS III+ in January 2003, and the reason their prices are different is that they each use a different mark-up rule. It appears that The Offroad Store, the firm that was previously the cheapest, is now experimenting with a higher price, whereas Expansys is being less ambitious than before and is charging a price that matches the most commonly quoted price almost exactly. The ASK Direct price, once about 10 per cent above the most popular price, has been cut drastically to make it the best deal, but this might be more in the nature of a ‘special offer’ than something that the firm expects to maintain. Overall, the messages are mixed: perhaps we should infer that if the market worked as in our model equilibrium prices of the GPS III+ and GPS V Deluxe would be £290 and £360, respectively, and there are two suppliers that consistently charge prices that are
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higher by similar amounts. Instead of using the mainstream model in this context, perhaps we would be wiser to apply the heterodox perspective. The latter both questions how well informed the consumer will be and suggests that prices are often set with the aid of simple mark-up rules (see Chapter 7). It might be a better framework for interpreting what is going on in this market, as least in respect of some of the firms.
2.8 The mainstream view of economic systems Mainstream economists work at two levels of analysis when theorizing about how economies work: at the level of the market (partial equilibrium analysis) and at the level of the economy as a whole (general equilibrium analysis). Our mainstream-style model of the hot dog market is an example of partial equilibrium analysis. Though simplified, the story we told was rather more complicated than the basic vision of how markets work that underlies mainstream economics. This vision can be encapsulated in a supply and demand diagram such as Figure 2.3. It is important to be completely clear about what the supply and demand curves on such diagrams represent. A supply curve shows how much of the product in question suppliers will be prepared to offer for sale if they expect to be able to get particular prices for it in the product’s market. The supply curve in Figure 2.3 is assumed to be upward sloping on the basis that if more is to be produced, a better deal will have to be offered to lure additional resources away from other uses. This may not be a good assumption if there is
Price
Supply
P`
P∼ P* P^^ P^ Demand
Q*
Figure 2.3 Convergence to equilibrium in a market
Q∼ Q`
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unemployment or firms are working with spare capacity. A supply curve’s position is fixed so long as ceteris paribus (other things being equal) holds – i.e. as long as nothing but the price of the product in question can be changed. If any other factor affecting supply changes, then a supply curve may shift to the left or the right. For example, adverse climatic conditions may cause a decline in output of a crop used as an input in production, thereby shifting the supply curve to the left. Conversely, improvements in technological knowledge may make it possible to produce the product more cheaply, thereby shifting the supply curve to the right. A demand curve shows the relationship between the price of the product in question and the number of units that can be sold in the period in question. The demand curve in Figure 2.3 is drawn sloping downwards to the right on the presumption that in order to get people to buy more of the product, a better deal will have to be offered. As with the supply curve, it is drawn assuming ceteris paribus, other things being equal. A rise in consumer incomes could cause the curve to shift to the right (if the product is a luxury), whereas a fall in price of rival products or adverse news about the product could cause a leftward shift in the demand curve. At price P* and quantity Q*, where the supply curve and the demand curve intersect, the amount that customers are prepared to buy and the amount that suppliers are willing to offer for sale are equal. If this is the actual price and quantity, then co-ordination has been achieved and the market is in equilibrium, since neither the buyers nor the sellers have an incentive to change what they are doing. Central to the mainstream perspective is a belief that, if a market is not initially in equilibrium, the way that people respond to losses or above-normal profits caused by a co-ordination failure will sooner or later cause the market to converge to the equilibrium point. For example, suppose that suppliers have expected a price of P` rather than P* and hence have tried to sell Q` rather than Q* units in the period in question. To dispose of Q` units, the price will have to be lowered to P^, which means that much of the supply will have been offered at a loss. (Precisely how much revenue the firms get will depend on whether, during the period in question, they gradually lower the price or drop it suddenly early on after realizing how slowly their stocks were moving.) Next period, in an attempt to avoid repeating these losses, suppliers will expect a lower price than P`, say P~, and will therefore offer rather less, moving down the supply curve to Q~. If so, they are still producing more than the equilibrium quantity. The price will have to fall to P^^ for all the output to be sold. The continuing loss is an incentive to cut output further and eventually they will stumble upon the P*, Q* combination, rather as if they had been
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guided there by some kind of ‘invisible hand’. Conversely, if initially too little is supplied, the fat profits that ensue will provide an incentive to expand production somewhat and again the market will move towards equilibrium – where the price that the marginal buyer (the least-willing buyer) is prepared to pay is the same as the price required to make suppliers willing to offer that extra unit of output. In short, although there may be problems of information and knowledge that result in temporary co-ordination failures in a market, profits and losses provide incentives to adjust production and correct errors in choices of output. Markets, it would appear, tend towards stable equilibrium positions. A general equilibrium perspective takes into account the interconnections between markets and dispenses with the ‘all other things being equal’ assumption in respect of relative prices and incomes. In its most basic form it simply takes the following three things as fixed for the time period under consideration: ◆
The set of technological possibilities limiting the relationship between possible combinations of inputs and outputs.
◆
Consumer tastes and information about how products relate to those tastes.
◆
The physical and financial assets and individual capabilities that market participants have at the start of the period.
Given these three kinds of data, and assuming that tastes and technology imply downward-sloping demand curves and upward-sloping supply curves, then a set of equilibrium price/quantity pairings may exist that would ensure simultaneous equilibrium in all markets for outputs and for supplies of inputs, including labour services. The task of finding a state of general equilibrium is much more demanding for the price mechanism than is the attainment of equilibrium in a single market. Suppose there has been under-supply and big profits in one market. If resources are moved into that market they might come from markets that were previously in equilibrium but not able to offer the abnormally high returns of the market into which they are being moved. Meanwhile, those who, say, earn overtime payments for producing more of the product whose supply is being expanded may then spend their extra income on luxury products and cease demanding goods of lower quality, thereby disturbing equilibrium situations in the latter markets. Adjustments in the latter might disturb yet other markets and so on. The common presumption is that the responses to changing relative prices, profits and losses in the economic system will eventually sort it all out, even though the most sophisticated of general equilibrium researchers have been careful to point out that this can only be assumed under very restrictive conditions.
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Now, if everyday experience suggests that the economy operates typically in a reasonably orderly manner, one thing that it might seem logical to assume is that the economic system is organized in something approaching a modular form, such that adjustments and imbalances in one market have ripple effects for only a select set of other markets. Mainstream economists take a different logic, however, one that reflects a vision of markets and the price mechanism as a giant machine crunching out solutions to a huge set of simultaneous supply and demand equations. When they think formally about how the ‘forces of supply and demand’ work in the economy as a whole they do so by characterizing the economic system as if it is what physicists and mathematicians call a ‘field’. A field is a system in which everything is connected to everything else. In this setting, the idea of a ‘field’ is exactly the same as a gravitational field in astronomy. If adjustments take place in a number of markets in a particular period, the theory proceeds as if every pair of markets is directly linked, rather than coming about via a particular set of ripple effects going from market A to market B to market C and so on. So, just as distant Pluto might exert a small but direct pull on Earth, and vice versa, with both planets also interacting directly with the orbit of Jupiter, etc., so a mainstream economist is prepared to imagine prices and quantities of, say, yak milk in Tibet as being affected by, and affecting, to some degree the prices and quantities of hang-gliders sold in Wales, handguns sold in Texas and so on. To tell a coherent story of how the ‘everything affects everything else’ force-field view might operate in the world of business, it seems necessary to assume that: ◆
any buyer is free to interact with any seller;
◆
even if in reality different types of goods are not seen as direct substitutes in a physical sense (would you use a tube of toothpaste as a substitute for a tube of moisturiser, or vice versa?), in practice all goods are indeed substitutes in an economics sense (a rise in the price of moisturisers may lead a consumer to economize on spending elsewhere to keep using it, which may include switching to a cheaper brand of toothpaste; or consumers might cut consumption of moisturiser and spend more elsewhere, including spending more on toothpaste);
◆
markets are very easy for producers to enter and exit;
◆
buyers and sellers can very easily obtain information about what is available, its location, price and quality;
◆
buyers and sellers have no compunction about switching to other sellers and buyers if they perceive a better deal.
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This might seem an unrealistic set of requirements at first glance but for the past two decades policymakers following the advice of mainstream pro-market economists have been changing the rules of the economic game to make the real economy much more like this theoretical ideal. The deregulation of markets and removal of barriers to trade between countries, coupled with the rise of the Internet, have greatly increased awareness in business that competition can come from anywhere on the planet. Consumers can bypass traditional sources of supply and distribution systems and obtain products more cheaply by using their credit cards to make email orders from distant lands. Global financial markets never close and events in a relatively small economy such as Thailand may generate repercussions in much larger economies all around the world, as happened in the Asian economic crisis of 1997. Workers may be internationally mobile, but jobs in developed nations can suddenly evaporate as production is switched to emerging low-wage economies. While this globalization of markets may seem very much a contemporary phenomenon, it can be seen as a return to what was happening between about 1870 and 1914, before the rise of interventionist government policies and protectionist approaches to trade in the face of high unemployment. During that period, the invention of the telegraph and telephone linked together markets all around the world, and millions of people migrated freely. And it was in precisely this period that the core ideas of mainstream economics were developed. Even in the era of trade barriers and market regulation, some parts of the world economy continued to operate in terms of a global free-for-all, with very strong competitive pressures. Tramp steamers, for example, could be readily purchased secondhand, were inherently mobile and capable of being registered under flags of convenience and, if the potential profits were attractive, could sail between any pair of ports where cargos were to be found.
2.9 The heterodox view of economic systems and
co-ordination Challenges to the mainstream view of economic systems come from many different schools of economic thought, but they implicitly share a common central theme, namely, that if we are to make sense of how the economy works we need to focus on patterns of connections between elements of the economy seen as a complex system. A complex system is a system in which the network of connections between its component parts is incomplete.
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A field
A complex system
Figure 2.4 A field and a complex system
From this standpoint, the ‘field’ view of an economy is not really portraying it as a system, since if everything is connected to everything else the whole has no structure. The heterodox viewpoint is much more like chemistry than the Newtonian physics that mainstream economists seek to emulate. Chemists are essentially interested in molecular and crystalline structures – note, for example, how graphite and diamonds are both made of carbon but differ in the way the carbon atoms are organized and hence have very different properties – and in how certain kinds of elements react with each other. Likewise, the heterodox economist believes that structures matter for determining how well markets operate and how firms and consumers survive, grow and evolve. Figure 2.4 contrasts field and complex systems in graphical terms. Heterodox economists apply the complex systems idea at a variety of levels. The economy as a whole can be seen as a complex system of partially interconnected elements. These elements are themselves complex systems, made up of complex systems: ◆
Firms and networks of related firms (as we emphasize in Chapters 9 and 10).
◆
Consumers with both lifestyles of interlocking consumption activities and networks of social relationships with other consumers.
◆
Products that involve multiple technologies or ingredients that have to be assembled in particular ways for the products to function properly.
Heterodox economists think in terms of a very different set of ideas that account for, or are a consequence of, this partial connectivity: ◆
Problems of knowledge – and costs of marketing – limit the set of parties with whom any buyer or seller might try to deal.
◆
People are not always willing to make trade-offs even in the event of large changes in relative prices. In some parts of their lives, rather as in university degree regulations, they may impose structures involving priorities or
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prerequisites. In other words, whether or not something ‘fits’ may be the crucial requirement, and a poor fit may not be compensated for by being offered more in some other respect, such as a cheaper price. ◆
A lack of knowledge/specific capabilities may make markets difficult to enter; knowledge problems may make markets difficult to exit, too, by making assets hard to dispose of for anything like their initial prices.
◆
Difficulties in obtaining information in markets may lead to brand loyalty and brand equity – buyers do not set out to fill in all the gaps in their knowledge and instead stick with particular familiar brands even if these have premium prices.
◆
Since buyers and sellers both benefit from getting to know each other, trade is often based on stable relationships.
◆
It may be unwise to focus on individual product markets as buyers may be thinking of where they can get the best value in terms of an entire bundle of related products. (This might help to account for some of the dispersion we saw in the pricing of GPS products. The retailers of these systems were selling different mixes of products for different parts of the outdoor leisure market and hence might not all see themselves as rivals. Neither might the consumers categorize yacht chandlers as competing with off-road accessory suppliers. Hence they might not bother to compare their prices, even though both sell GPS products.)
◆
History matters. Economic processes are path dependent: the set of possibilities open to decision makers today, and the perceived pros and cons associated with each of them, is shaped by previous decisions that lock the economy into particular ways of doing things (for example, Microsoft Windows computer operating systems and VHS video systems).
◆
Economic systems may evolve at times in a discontinuous manner, whilst at other times changing slowly as if moving down a well-defined pathway.
◆
The structure of connections may affect the ability of the system to adapt to change and its resilience when subjected to shocks that disrupt particular connections.
◆
It may be counter-productive to make the system more like the mainstream economist’s ideal.
Heterodox economists thus tend to highlight rather different features of the real world economy than those emphasized by mainstream writers. For example, if thinking about the shipping industry a heterodox economist would tend to emphasize not the tramp steamer part of it but, rather, that: (a) certain nations
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(such as Greece and Norway) have a disproportionate representation in terms of ship ownership; (b) shipping companies tend to operate fleets of vessels; (c) cargo transportation is nowadays based around a technology standard, namely, the container system; (d) after reliable steam power was applied to ships in place of wind-dependent sails, regular timetabled ‘liner’ routes emerged, linking particular pairs of ports; and so on. Moreover, whilst they do not dispute the facts suggesting trends towards globalization of markets and the increasingly interconnected nature of modern financial systems in different countries, heterodox economists see an ongoing role for networks of partial connections in the modern economy: ◆
There is still a place for physical financial centres in a world of virtual financial markets, since mixing with people face-to-face enables better access to hints of possible deals of significance, and enables those engaged in deal making to pick up nuances regarding the quality of information disclosure and bargaining strategies of their trading partners.
◆
The wider the range of financial possibilities that are open to us, the more we may need to build up relationships with investment advisors who understand our needs and whom we can trust.
◆
Despite the power of Internet search engines for uncovering what is available and exposing any differences in price and quality of rival suppliers’ offerings, the sheer range of businesses with whom we might deal is potentially overwhelming and we cope by bookmarking trusted websites and navigating the World Wide Web via specific linkages between websites.
More generally, the heterodox way of approaching economics looks at factors other than adjustments of relative prices as means of achieving economic coordination. The mainstream picture concentrates essentially on error correction, ignoring how the structure of the economic system might limit co-ordination failures in the first place. For this reason, heterodox economists do not rule out the possibility that in some contexts markets may be inferior to systems based on planning. The pursuit curve story illustrated in Figure 2.5 is a thoughtprovoking parable on this theme, from Maurice Dobb (1967), one of the great socialist economists of the last century. In Dobb’s tale, a dog sees its owner cycling in the distance and starts running towards him, not realizing that he is going in a different direction. After a while the dog notices that she is no longer on course for her owner and changes track. The trouble is, her owner still has not seen her and keeps going. More time passes and the dog once again realizes she is no longer on track. And so the process is
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Owner
Dog
Figure 2.5 The pursuit curve: error correction versus planning
repeated. If only the dog were able to assess her master’s speed and direction of movement properly, she could take the bold step of calculating the best path to take to get to where he will get to if she takes the quickest path to meet him (as shown by the long, straight, dashed arrow). It should be noted that Dobb warns that the parable should not be taken too far: planners may actually want to take the economy in a different direction rather than to where the price mechanism might eventually take it. Dogmatic opposition from mainstream economists means that economic planning is out of fashion at the level of the economy as a whole in many countries. These economists often fail to recognize that planning is actually the means by which much resource allocation is done, in conjunction with face-toface co-operation, within businesses as they compete in markets. At the interfirm level, too, there is a substantial element of informal planning of various kinds, such as the use of co-operative relationships, interlocking company directorships and hierarchical relationships between major contractors and subcontractors to ensure that projects get completed without major cost overruns. Competitive price tenders may determine which firms win particular supply contracts, but prior relationships will count if several contractors are otherwise equally attractive. The voice mechanism may then play a major role in the implementation process for dealing with surprises and filling in details not fully spelt out at the time the deals were done. In later chapters of this book we will explore these essential features of the business world in some detail. For the present, we will end our analysis of markets by presenting a heterodox view of the nature of markets as devices that make transactions easier to do in a world of problems of information and knowledge.
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2.10 Markets as institutional structures Mainstream economics has surprisingly little to say about the nature of markets, despite many of its proponents being very willing to describe themselves as ‘promarket’. Insofar as they go beyond seeing individual markets as trading arenas, it appears that they see a market system essentially as a legal arrangement in which individuals and privately owned businesses are free to do deals with each other if they can arrive at mutually beneficial prices. In terms of heterodox economics, giving people the right to trade as they please does not guarantee that the economy will work very effectively – the experience of many post-communist nations provides a cautionary lesson in this respect. A free-enterprise system has a much better chance of avoiding coordination failures and wasted opportunities for mutual benefit if its markets have evolved to be markets in the following sense: A market is defined in heterodox economics as a system of social institutions that help buyers and sellers reduce transaction costs. A market of this kind reduces transaction costs in the sense that it enables buyers and sellers to: ◆
find each other easily and make price comparisons;
◆
judge effectively whether trade is likely to be mutually beneficial in terms of product quality, safety and standards of service;
◆
co-ordinate the fit between products (via standard sizes, measurement systems, physical interfaces, etc.);
◆
obtain redress in the event that a deal results in an unsatisfactory outcome, such as a dispute between the buyer and seller over what has been delivered, the failure of the buyers to make payment, or the failure of the good or service to be delivered in whole or part due to the financial collapse of the supplier. Institutions are features of everyday life that have been around for some time and are widely known and taken for granted in social interaction; more formally, they are systems of embedded social rules.
Market institutions include: ◆
◆
Trade associations, that, for example, co-ordinate standards of service offered by members and monitor them, or operate insurance funds to guard against customers suffering losses in the event of a member going out of business (as with an association of travel agents). Yellow Pages and other business directories.
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Tendencies of suppliers to stay in the same line of business for long periods and to try to make a name for themselves there.
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Conventions used in setting prices, such as holding prices steady in the face of fluctuating demand (except for well-known ‘sale’ periods, such as the New Year).
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Districts or particular roads known for groupings of particular kinds of firms, such as Silicon Valley, Hollywood, Madison Avenue, Broadway, the City of London, Fleet Street or Soho. These are known in the modern literature as ‘Marshallian business districts’ after Alfred Marshall, who drew attention to them over a century ago.
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Trade fairs, business conferences/conventions and exhibitions that enable rival suppliers and would-be customers to mingle with each other and gather intelligence about where the market may be heading.
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Trade press and other regular, well-known advertising forums.
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Websites that provide information on product reliability, specifications and prices (e.g. www.jdpower.com or www.redbook.com.au).
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Experienced consumers, known for their expertise and willingness to share it.
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Voluntary codes of practice under which suppliers are widely known to be operating.
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Product standards for size, physical connections and functional compatibility (for example, imperial/metric doors and tools, 240 volt/50hz power supplies, ISO 9000, BSI Woolmark, DIN and Phono cables).
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Statutory requirements, such as product safety and environmental protection legislation, or requirements that suppliers should be licensed and subject to periodic monitoring by a regulatory authority.
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The presence of anti-monopoly bodies (such as the Competition Commission in the UK) and consumer watchdog groups (such as the Consumers’ Association) and their reputations (or lack of them) for stepping in when customer interests are threatened by suppliers’ policies.
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Laws and legal institutions, including bodies such as small claims courts.
A moment’s reflection on the process of buying or selling a used car, having an evening out or getting a plumber to fix a burst pipe should indicate how much we may miss the point about how the economy works if we focus too much on changes in relative prices and ignore the vital role such institutions play in enabling transactions to be organized with little fuss. Statutory intervention is not always an important part of a market, for firms that aim to be long-term
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suppliers may recognize that it makes sense to set up trade associations and assign them powers of accreditation and exclusion from membership, for this will enable customers to choose suppliers with more confidence. Paradoxically, the need for state regulation is often just as great when markets fit the mainstream ideal of being very easy to enter, as it is when markets are dominated by just a handful of suppliers and entry by others is difficult. There is a simple reason why unregulated easy-entry markets may be dangerous for customers: too many firms may try to operate in them, which makes it very hard for them to make any money and leads some to take devious steps to cut costs. It is important to understand that not all exchanges take place in markets. For example, if you sell an old computer to your neighbour as a result of a chance conversation over the garden fence, this is a one-off case of bilateral exchange; it is quite different from selling it at a widely known venue for ‘car boot sales’ or after placing a small advertisement in the local paper’s ‘computers’ section. You might also engage in relational exchange with your neighbour, such as minding each other’s homes when one of you is away on holiday; once again, no market is involved. It might also be tempting to say that unique commodities cannot be the subjects of market exchange. However, we make sense of the world by pigeon-holing things in terms of their likenesses and differences with other things; hence even a unique product may be capable of appraisal by a known expert in the area into which it seems to fit and be advertised in the regular media used in that area, even if it only changes hands very occasionally.
2.11 The firm as an answer to market failure Although markets of the kind just described make it much easier for buyers and sellers to do mutually beneficial deals, compared with how things would be in a world without them, they are not always the best means for changing the allocation of resources. They reduce transaction costs but they do not eliminate them altogether, leaving plenty of scope for certain kinds of market-based changes in resource allocation to work out badly or be impossible to arrange at all. Economists owe their awareness of the costs of using markets to Ronald Coase, winner of the 1991 Nobel Prize in economics. In 1937, very early in his academic career, Coase wrote a classic article that used the presence of such costs to help explain why firms exist. Coase’s analysis centred on the possibility that what we call voice and planning mechanisms inside firms might be a cheaper means than markets and the price mechanism for allocating resources. His article is really about what limits the size of a firm that already exists and thereby stops more and more things that might be the subject of market transactions from being conducted on the basis of directives inside firms.
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However, his basic insight that problems with markets provide a rationale for firms seems to offer a good way to answer the question that we posed at the start of this chapter, namely, why do people bother to set up firms as a means of making money? For many who decide to start a business as an alternative to being employed by someone else, the reason may not be a vision that they will make a fortune through a unique entrepreneurial insight. Rather, it may be simply that, as far as they are concerned, the labour market is failing them. Becoming one’s own boss is a way of avoiding or escaping from: ◆
long-term unemployment due to one’s skills no longer being in demand;
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having repeatedly to find a new job at the end of a temporary contract or because employers keep cutting back on staff;
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having to fit in with the working hours demanded by employers, which may be incompatible with, say, family commitments;
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feelings of alienation that come from being bossed around or being a tiny cog in a giant machine, with little control over one’s pace of work;
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missing out on the tax and financial advantages of running a business rather than being an employee, including scope for illegal tax evasion by accepting payment from customers in cash, or access to preferential leasing deals on cars and scope for claiming expenses against income tax.
Many of those who start businesses for these kinds of reasons may lack entrepreneurial abilities in terms of seeing scope for a new business. If so, it is still possible for them to get started by buying a business idea from someone else in ready-to-go form. This is the essence of owning a franchise, which is how, for example, many McDonald’s outlets come into existence. Although, as the McDonald’s franchise example indicates, it is possible to develop a business idea and sell it to others, people with ideas for business ventures often conclude that the only way to get them up and running is to do it themselves by starting a firm. A person with what seems a potentially lucrative idea may run into the following problems in the market for ideas if they try to get someone else to put it into practice: ◆
Their current employers do not share their vision and will not put it into practice even if they are not demanding a slice of the returns that it generates.
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They believe the idea is worth far more to their current employers than any extra remuneration that they would receive as a consequence of suggesting it.
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They are wary of trying to sell it to someone else or to an existing business because of the risk of not being able to capture the value of what is, at the
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moment, this person’s own intellectual property. The market for ideas has a basic problem, raised by Nobel Prize-winning economist Kenneth Arrow and known as the Arrow Paradox: The Arrow Paradox states that for someone to know whether an idea is worth paying for, the seller must give them information about it, but once the information has been provided for inspection, they have got access to it without having to pay for it and as a result they may be able go and use it ‘for free’. This is the problem that retailers of consumer magazines face: if we browse at length in a magazine store, we can get the specific information we are looking for and then leave the store without buying the magazine; yet if magazines are displayed in sealed wrapping, how can we know whether the magazine will be worth buying? A person who has a potentially lucrative idea can try to protect it via the patent system or by doing whatever is required by copyright law to claim ownership of it prior to presenting it to companies that might be interested in buying it. However, even this may not be enough protection, for the firms they approach may be able to design a variation on it that does not breach their patent or copyright after turning the proposal down. Such firms may even be able to get their near-pirate version into production before the original. (As you will see in Section 5.2, precisely these issues arose early in the story of the Dyson Dual Cyclone vacuum cleaner.) ◆
They may be unable to find a buyer for their idea. Those whom they approach may be genuinely pessimistic about the likely volume of demand or the scale of development costs required to turn the concept into a production-ready reality.
◆
Quite apart from the financial side, they may simply be interested in seeing their idea turned into a production reality and fear that this will not happen if the only parties interested in buying it have an interest in suppressing it because it threatens to render their existing investments obsolete. Of course, devious behaviour by such a purchaser could also have major financial implications: if they sold the firm a licence to use their idea with a per-unit royalty payment on sales of the product embodying it, they might simply receive a lump sum and no subsequent royalty earnings. At the very least, they would be wise to devise a licensing deal of finite duration or one with clauses under which it would expire if not put into operation within a particular period. Such complexities in the deal could entail major legal bills with still no guarantee that production will ever occur.
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2.12 SUMMARY
◆
If the idea is not completely spelt out in a contract by which it is sold (for example, due to problems of tacit knowledge), there is a risk that the party to whom it might be sold will not implement it in the manner that they envisage. This could happen due to opportunism by the purchaser or simply because, despite the ‘best will in the world’, the purchaser of the idea doesn’t quite ‘get’ it. Once again, if the person with the idea values being able to see it implemented for its own sake and not in, say, a ‘dumbed down/Hollywood’ version, this may be a major stumbling block. Implementation in an edited form might also be bad for financial returns if these are based on royalty payments and sales suffer due to the production version not matching the person’s original vision. Those who sell their ideas purely in the hope of making money from them need to be confident that those to whom they entrust scope for making changes to improve earnings know the product’s market better than they do.
Those who start their own businesses may avoid such problems but, as you will now be recognizing, everything has its cost and they may find they have jumped out of the frying pan and into the fire, facing a host of other problems that need answers. In the chapters that follow we first explore the nature of entrepreneurship and then examine the questions that an entrepreneur will need to address in trying to create an enduring business.
2.12 Summary In this chapter we have attempted to give a flavour of how mainstream and heterodox economists think about markets and the nature of economic systems in which decision makers participate as buyers and sellers in order to reap benefits from specializing rather than trying to be self-sufficient. We pointed out that the use of managerial hierarchies inside firms as a means of allocating resources is an alternative to letting market prices reconcile the different demand and supply offers of buyers and sellers and we emphasized the information problems that market participants often face. In the mainstream view, these problems are not emphasized because of presumptions about the error-correcting capabilities of the price mechanism – the way that people will change what they buy or sell as relative prices and profit opportunities change. In the heterodox view, these problems are often made less acute by the evolution of market institutions. Even so, as we emphasized in Chapter 1, problems of information and knowledge still overshadow many
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2.12 Summary (continued)
economic decisions, making the action of choosing very much a heroic leap in the dark in some contexts. Sometimes, to get around difficulties they have experienced in making acceptable deals in markets for labour and for ideas, people start their own businesses.
2.13 Some questions to consider 1. Examine the problems that unregulated market forces might have in coordinating supply and demand in a rapidly growing tourist centre. How might the local government authorities seek to reduce these difficulties? What kinds of market institutions might evolve to reduce them? 2. How would you explain the fact that, in many countries, the taxi market (a) is dominated by fleets of branded cabs rather than independent owner-operator cabs, and (b) is often subject to government regulation? 3. Why are international, multi-branch/franchised restaurants dominant in the supply of hamburgers and pizzas, whereas Chinese restaurants tend to be one-off and owner-operated? 4. Introduction agencies serve a similar role to banks and real estate agents in the sense that they are market intermediaries that bring together people who have got something to offer with other people who want something. Yet whereas banking and real estate are dominated by multibranch, nationally known business organizations, introduction agencies remain small-scale and unfamiliar to the general public. How would you explain this contrast? Do you think the rise of the Internet will cause the situation to change? 5. Why do prices of agricultural and mineral products tend to be less stable than the prices of manufactured products? 6. Examine the potential for supply and demand mismatches in the market for tertiary education services in both the short run and the long run, and the consequences of such mismatches for the broader community. As you answer, keep in mind that such mismatches can be in terms of the quality of education services and not just their quantity, so be sure to consider how education markets develop to handle the quality issue.
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2.14 RECOMMENDED ADDITIONAL READING SOURCES
2.14 Recommended additional reading sources If you wish to read more about how economists build models and argue about the worth of these models as contributions to knowledge, see Mark Blaug (1980) The Methodology of Economics: Or How Economists Explain (1st edn), Cambridge, Cambridge University Press. For a more controversial and engaging perspective, see the best-seller by heterodox economic model builder Paul Ormerod (1994) The Death of Economics, London, Faber & Faber (especially part I). For an excellent set of key readings, see Bruce Caldwell (ed.) (1984) Appraisal and Criticism in Economics, London, Allen & Unwin; however, if you have never read on the philosophy of science before, then it would be wise to begin with a short book by John Pheby (1988) Methodology and Economics: A Critical Introduction, London, Macmillan. Albert Hirschman (1970) Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations and States, New York, Norton. This short book explores adjustment problems in economic systems and highlights the importance of complaints (‘voice’) as feedback for improving resource allocation decisions, compared with the economist’s usual focus on dissatisfied buyers simply taking their business elsewhere (‘exit’). Hirschman also emphasizes how customer loyalty provides firms with some slack, enabling them to stay in business whilst trying to restore their relative competitive standing. Karl Sabbagh (1989) Skyscraper: The Making of a Building, London, Macmillan/Channel 4. This book is based on a television documentary series about the construction of Worldwide Plaza in New York and provides an excellent picture of the co-ordination problems involved in a project of this kind. It provided the basis for a case study by Peter Earl (1996) ‘Contracts, co-ordination and the construction industry’ in his edited volume Management, Marketing and the Competitive Process, Cheltenham, Edward Elgar, pp. 149–71. Figures 2.1 and 2.2 were inspired by Axel Leijonhufvud (1986) ‘Capitalism and the factory system’, in Richard Langlois (ed.) Economics as a Process: Essays in the New Institutional Economics, New York, Cambridge University Press. The work of George Richardson provides perceptive reflections on how different methods of resource allocation work, and how co-operation is a vital part of a modern competitive economy. At this stage, the most relevant of his works to look at are two of his articles: ‘Planning versus competition’ (from Soviet Studies, 1971, 22, pp. 433–47) and ‘The organization of industry’ (Economic Journal, 1972, 82, pp. 883–96). Both of these are reprinted in the 1990 edition of his book Information
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and Investment, Oxford, Oxford University Press. Richardson’s other work focuses on problems with the mainstream supply and demand story that we have not revealed in this chapter; they are raised in Chapter 9. For an interesting discussion of some markets in which consumers do not seem as willing to switch between suppliers as mainstream economists often presume, see Michael Waterson (2003) ‘The role of consumers in competition and competition policy’, International Journal of Industrial Organisation, 21, pp. 129–50. For an information-centred reflection on problems with attempts to replace socialist systems with markets in the former Soviet Union, see the work of 2001 Nobel Prize winner Joseph Sitglitz (1994) Whither Socialism? Cambridge, MA and London, MIT Press. Jason Potts (2000) The New Evolutionary Microeconomics: Complexity, Competence and Adaptive Behaviour, Cheltenham, Edward Elgar. If you are interested in exploring the ‘field’ versus ‘complex system’ contrast between mainstream and heterodox economics, then this acclaimed book is the one to read, though it is probably best first to read Tim Wakeley’s review of it in the Journal of Economic Psychology, 2002, 23, 2, pp. 279–86. Thomas Friedman (1999) The Lexus and the Olive Tree, New York, Farrar, Giroux and Strauss; or John Micklethwait and Adrian Wooldridge (2000) A Future Perfect: The Challenge and Hidden Promise of Globalization, New York, Times Books. These are two of the best-sellers amongst the recent wave of books on globalization. Though at times lacking in critical insight, they both certainly give a good sense of the interconnectedness of the modern global economy, the vision of free-market thinkers and the importance of institutions in making markets work effectively. The ‘pursuit curve’ story depicted in Figure 2.5 is adapted from pp. 87–8 of Maurice H. Dobb (1967) Papers on Capitalism, Development and Planning, London, Routledge & Kegan Paul. The role of costs of using markets in explaining the rationale of firms is explored in Ronald Coase (1937) ‘The nature of the firm’, Economica, 4, pp. 386–405. Geoffrey M. Hodgson (1988) Economics and Institutions, Oxford, Polity Press. Chapter 8 of this book is particularly significant for its discussion of the role and nature of markets. Our discussion of why firms get created is partly inspired by one of Hodgson’s more recent works: ‘Opportunism is not the only reason why firms exist: Why an explanatory emphasis on opportunism may mislead management strategy’, Industrial and Corporate Change, 2004, 13, 2, pp. 401–18.
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3 What do entrepreneurs do?
Learning outcomes If you study this chapter carefully, it may help you to understand: ◆
the personal and cognitive qualities that can help an entrepreneur to succeed in business
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why the entrepreneur has a rather limited role in mainstream economics
◆
what is meant by ‘X-inefficiency’, and the role of the entrepreneur in combating it by getting staff to work harder or smarter
◆
why some economists see entrepreneurs as people who help steer the economy towards equilibrium, while other economists see entrepreneurs as disruptive agents of change
◆
the kinds of mental connections that successful entrepreneurs are particularly skilled at making.
To the extent that you develop such understanding, you should be better able to develop a more complete picture of the nature and role of entrepreneurship than the populist understanding by drawing together the different theories discussed here.
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Woolworths, the pyramids and the Internet have one thing in common: they started out as nothing but an idea. Guy Claxton (2001)
3.1 Introduction Without doubt the entrepreneur holds a special place in the collective consciousness of society; indeed some entrepreneurs have achieved fame or notoriety that is on a par with Hollywood superstars. The business exploits of a number of high profile entrepreneurs such as Richard Branson (Virgin), Anita Roddick (The Body Shop), James Dyson (Dyson) and Stelios Haji-Ioannu (EasyJet) are reported regularly in the media. These people, and others like them, are famous because they are successful in business. But what does an entrepreneur do? In this chapter we look beyond the populist conception of the entrepreneur and introduce a more rigorous analysis of this key actor on the economic stage. In particular we are interested here in identifying the economic role of the entrepreneur, because entrepreneurship lies at the heart of business economics and a better understanding of it will provide us with important clues about the sources of business success and failure. These are big issues. It will probably not have escaped your attention that we have started our discussion of the entrepreneur on the assumption that we all know one when we see one. It is not straightforward to define who or what an entrepreneur is, but by the end of this chapter you should be able to construct your own definition based upon the functions and activities that we identify as being entrepreneurial. To help us get started, we will take a look at the story of Richard Branson. We will then move on to examine what economists have said about entrepreneurship.
3.2 An entrepreneur’s story: the early years of
Sir Richard Branson Sir Richard Branson is a household name but this hasn’t always been the case, so, rather than focusing upon his most recent exploits, we will take a look at his early years because these provide us with important clues about the activities of entrepreneurs more generally. It is useful also because it suggests that certain personal qualities can help turn an original entrepreneurial vision into a successful reality. The start of the path which leads to the multi-business Virgin empire of today can be found back in Branson’s schooldays when he first thought of producing
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a national magazine dealing with issues relating to youth culture. This magazine, Student, was originally conceived in 1966 when Branson was just 15 years old. The initial spur to create the magazine came from Branson’s belief that various school activities such as corporal punishment, games, chapel and the school meal system were either organized inefficiently or were simply wrong, and the creation of an alternative school magazine would provide a forum to air these radical views. It did not take long, however, for this simple idea to metamorphose into a plan to create an interschool magazine and then for this idea to expand into a plan to create a magazine aimed at technical college and university students with a nationwide market. It should be noted that this transition of ideas took place at a conceptual level; Student was very much a concept inside Branson’s imagination. After much effort and persistence on the part of Branson and his friend Jonny Gems the magazine was launched some two years later in 1968. In the intervening period Branson had devoted a significant amount of time and energy to the task of persuading commercial organizations to take out advertising space in the magazine and also to persuading politicians and celebrities either to write for the magazine (for nothing) or to agree to be interviewed. In Branson’s own words, ‘I had the ability to persuade them to say yes, and the obstinacy never to accept no for an answer.’ We might add also that he displayed a lot of selfconfidence for a school boy. Interestingly, while the label ‘entrepreneur’ seems to be a natural one to apply to Branson, he claims that he became one largely by default as a result of taking care of the business side of Student while Gems took care of the editorial side of the magazine. The motivation behind the magazine was creative rather than money-making, which was seen simply as a necessary activity to keep the magazine alive. Later on Branson claims to have realized that business ‘could be a creative enterprise in itself’. He outlines his philosophy of business in the following terms: ‘Above all, you want to create something you are proud of … I can honestly say that I have never gone into any business purely to make money. … A business has to be involving; it has to be fun, and it has to exercise your creative instincts.’ Despite this claim, Branson realized that the now-established magazine was not making sufficient money to survive and this prompted him to explore ways in which he could develop the Student name into a travel company, an accommodation agency and an advisory centre among other things. The Student offices and the advisory centre exposed Branson to a variety of young people and it was this that revealed to him how important popular music was in youth culture: ‘One thing I knew from everyone who came in to chat or
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work for us was that they spent a good deal of time listening to music and a good deal of money buying records.’ This struck him as a business opportunity and, aided by the recent outlawing of resale price maintenance (RPM), he conceived of a discount mail-order record distribution business. Virgin Mail Order Records came into existence in 1970 with its first advertisement appearing in what turned out to be the last ever edition of Student. The business, which Branson shared on a 60:40 basis with his childhood friend Nik Powell, proved to be a great success; people were attracted by the fact that they could buy records from Virgin for a significantly lower price than that being charged by the two record-retailing giants WH Smith and John Menzies who, despite the abolition of RPM on the part of manufacturers, seemed content to maintain the status quo rather than engage in price competition. Branson had perceived a business opportunity and taken advantage of an attractive pricing situation. Throughout 1970 Virgin Mail Order Records thrived, but then potential disaster loomed in the form of a prolonged strike by Post Office workers in January 1971. With the postal system not working, money and orders stopped coming into the business, and records could not be sent out to customers. Given that the margins on the business were so small and the business was far from cash rich something had to be done, and quickly, to save the enterprise. In response to this crisis Branson demonstrated a very important trait – adaptability. The solution he arrived at was to open a shop, in other words provide an alternative distribution channel to customers. WH Smith and John Menzies were still sitting on their laurels to the point of displaying complete apathy towards the music-buying youth, so Branson created the first Virgin Record Shop above a shoe shop on Oxford Street in London. The ethos of the shop was based upon Branson’s belief that: ‘People take music far more seriously than many other things in life. It is part of the way they define themselves, like the cars they drive, the films they watch, and the clothes they wear.’ Consequently, customers were encouraged to lounge around on beanbags listening to music and discussing their potential purchases with interested shop staff. Once again Branson’s negotiating skills came to the fore as he persuaded the shoe shop owner to let them use the upstairs as a record shop rent-free. The whole process of saving the Virgin record business, from inception to execution, took about one week. On the back of a concerted localized advertising campaign consisting of leaflet distribution in Oxford Street the shop took off and as time passed the sales staff began to report that the same people were coming back to the shop on a regular basis; it became clear that a loyal customer base was developing and with it so was the Virgin reputation. Key to the establishment of the reputation was Branson’s
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cousin Simon Draper who had an acutely developed sense of taste about modern music. Draper was adept at using his knowledge of music to predict which bands’ records would sell well before the bands had become successful. His reward was to be employed as chief record buyer on the standard Virgin wage of £20 per week. Complementary to Draper was John Varnom, who had a talent for record promotion and advertising. Branson, however, was not content; retail margins were small, particularly given the discounted prices being charged for records, so he sought out business opportunities that might offer a bigger margin. He saw that the people who were making serious money in the record industry were the record companies. Branson had heard that recording studios were a very formal place with rather strict scheduling from the early morning onwards. This seemed to be their weakness. Just like the contemporary record retailers, the recording studios did not seem to be run in such a way that they catered sufficiently to the needs of their customers – the bands who used them. As Branson observed: ‘The idea of the Rolling Stones having to record “Brown Sugar” straight after finishing their bowls of cornflakes struck me as ridiculous. I imagined that the best environment for making records would be a big, comfortable house in the country where a band could come and stay for weeks at a time and record whenever they felt like it, probably in the evening.’ As a result of this belief, Branson began to search for a big country house that would be suitable for conversion to a recording studio. Having located a suitable manor house in Oxfordshire a mortgage was arranged and all hands were drafted in to convert it into a recording studio. Instrumental in this process was the Virgin employee Tom Newman who had the knowledge required to create a recording studio that was as least as good as the major London studios. Branson meanwhile continued utilizing his skills of persuasion to attract bands to the Manor recording studios, which became fully operational in early 1972. Increasing the number of record shops was also on the agenda throughout the tail end of 1971 and all of 1972. By the end of 1972 14 shops had been opened across the UK on a cleverly designed schedule (one a month), where Branson used his negotiating skills to ensure that minimum rent was payable and that each shop had a three-month rent-free period after the initial opening. In this way revenue from successful openings could be used to pay the rent of earlier shops as it fell due and the losses from a failed shop could be minimized. In essence, Branson’s approach here revealed that he was prepared to experiment in the market place but he always ensured that the downside of any risky venture was minimized. As he said: ‘… when we opened we knew that the record
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sales in the first three months would help pay for the rent on the previous shop that we had opened. The sales also demonstrated, without committing to a huge overhead, whether the site we had chosen attracted enough people off the streets to make the shop viable.’ With the Manor recording studios in place and the string of shops Branson further expanded the reach of the Virgin business in 1973 by starting a record label. Here he used Simon Draper’s expertise once more by appointing him as the talent scout and gave him a significant incentive to do the job well: 20 per cent of the company called Virgin Music. Once again, Branson demonstrated his willingness to take risks. It was usual for newly established record labels to license their records out to other companies who took responsibility for manufacture, distribution and, crucially, promotion while offering an upfront payment and a royalty stream from successful albums. Of course this meant that the other company got most of the upside from successful records since they kept the majority of the profits. Instead Branson was confident that they should simply pay another record company to manufacture and distribute their records while Virgin Music took on the job of promotion (the costly part of the business), and therefore carried the risk but also had the opportunity to enjoy larger profits if their signings were successful. This meant that Draper’s role would be crucial, because his signing decisions would be exposed to the harshest of tests and Virgin Music would stand or fall on the quality of his choices. Virgin Music’s first signing was the then-unknown Mike Oldfield, but everyone who heard the early recordings of what eventually became the record Tubular Bells was certain that the company had something unique to promote and sure enough as Branson puts it: ‘Our gamble that we could promote it ourselves made us our first fortune.’ Tubular Bells was a runaway success and by the end of 1973 Virgin consisted of three mutually compatible businesses: a recording studio, a record label and a retail network. Lessons from the Richard Branson story
This story of Richard Branson’s early years as an entrepreneur contains several clues about the role of entrepreneurs in general and also the personal qualities that help generate success. It is an interesting exercise to re-read the brief account we have written above to see if you can identify key words or phrases that seem to describe what entrepreneurs do. Such a list may contain the following: ◆
take risks
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make decisions about entering markets
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3. 3 SIX PERSPECTIVES ON THE ECONOMICS OF THE ENTREPRENEUR
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exercise foresight, exercise creativity
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employ other people
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persuade
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sell, make things happen
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create companies
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perceive business opportunities
◆
manage the workforce.
This list is far from complete and we would encourage you to construct your own, but it does serve to illustrate some of the things that people like Richard Branson do that lead us to the unanimous view that he is indeed an entrepreneur as opposed to the apparently more mundane and common business administrator. Of course lists of descriptive phrases are no substitute for deeper analysis, so with this in mind we will turn our attention to the work of economists who have attempted to construct rigorous theories of the entrepreneur.
3.3 Six perspectives on the economics of
the entrepreneur When it comes to analysing what entrepreneurs do economists have developed several perspectives. If you have read Chapter 1 this probably won’t surprise you! The aim of economists has been to analyse what it is that entrepreneurs do that distinguishes them from other economic actors and consequently to assess the relative importance of their role in the economy. It might seem obvious to the casual observer that entrepreneurs perform a crucial task in the process of wealth generation in the economy, but the detail of how they achieve this needs to be understood. From the perspective of the individual with aspirations to become an entrepreneur the theories provide a host of valuable practical insights about the nature of the role and the type and breadth of issues that entrepreneurs need to consider and deal with. In order to keep our discussion manageable we will build up our picture of the entrepreneur in gradual stages by addressing each of the major perspectives in turn. You will see that each perspective has something useful to contribute to a more complete understanding of the entrepreneurial function. You will discover also that many of the topics we discuss here have implications that go beyond the study of entrepreneurship per se.
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3.3.1 The mainstream perspective on the entrepreneur The mainstream treatment of the entrepreneur is intimately bound up with the mainstream theory of the firm. Essentially the theory of the firm examines how scarce factors of production, which fall into one of three broad categories – land, labour and capital – should best be used in the production of goods and services for society. Within this framework, the entrepreneur is identified as the fourth factor of production. In contrast to heterodox economists’ focus on problems of information and knowledge, mainstream economics presumes that people are always looking out for, readily perceive and act upon opportunities for improving their positions as much as possible. One implication of this presumption is that everybody has what it takes to be an entrepreneur. In other words, mainstream theory treats entrepreneurs as if they were a resource with an infinite supply. If something is in infinite supply economists tend not to pay much attention to it because economics focuses on how best to use scarce resources. It is partly for this reason that mainstream economics has not developed a specific theory of the entrepreneur. This is not to say that entrepreneurs have no part to play in the mainstream theory of the firm, it is just that their role is trivialized. In the mainstream theory entrepreneurs are the founders, the owners and the managers of the firm all rolled into one and are responsible for organizing the other factors of production so that the firm can produce a good or service to sell to customers. They reside in a world where economic agents have full information about: ◆
the availability of factor inputs;
◆
the quality of factor inputs;
◆
the variety of ways in which factor inputs can be combined; and
◆
buyers’ demand for the firm’s product.
As a result, the practical questions that would face and challenge a boundedly rational real world entrepreneur, such as those faced by Richard Branson, effectively become automatic choices. In particular, two things are glossed over by the theory of the firm. The first is the question of how the business opportunity which led to the founding of the firm was recognized in the first place; here mainstream economics simply assumes that business opportunities will be automatically recognized and acted upon. The second is how entrepreneurs decide on the best way to organize and use the productive resources under their control. The assumption here is that if
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two entrepreneurs had access to the same quantity and quality of factor inputs, then we should expect both entrepreneurs to utilize and organize these factors in an identical way within their respective firms. In other words, the rival firms would not only be as efficient as each other, but each firm would also be expected to operate at optimum efficiency. We should point out that anybody who understands how the mainstream theory of the firm evolved appreciates that it was never intended to be a platform from which advice could be offered to entrepreneurs and business managers in the first place. It is instead a small part of a much bigger theory about how competitive markets work (we discuss this in Chapters 2 and 7). It is worth noting, however, that, despite this, it has been used in the field of strategic management to offer advice to firms as they seek to gain a competitive edge (often called competitive advantage) over their rivals, and this has had important implications for actual business decisions and behaviour. Because the theory expects that any two entrepreneurs will make identical and optimal decisions for any given bundle of factor inputs, it follows that a firm can only obtain an edge over its rivals if it has ownership/access to factors of production that are not available to its rivals for some reason. In other words, competitive advantage derives from the ownership of unique physical assets rather than unique intellectual assets such as the knowledge and the imagination of the entrepreneur. Casual empirical observation suggests that this view of the source of competitive advantage is incomplete because the variable quality of decisions made by real world entrepreneurs seems quite clearly to make a difference to the success or failure of firms. One economist who has taken this point seriously is Harvey Leibenstein, who suggested that firms would not necessarily use resources as efficiently as the mainstream theory of the firm implies. In doing so, Leibenstein opened up an important role for the entrepreneur in economic theory. 3.3.2 The entrepreneur and the inefficient firm Leibenstein coined the phrase ‘X-inefficiency’ to describe the key feature of his theory of the inefficient firm. X-inefficiency is defined as a state where the firm is underutilizing its resources for some reason and as a result its costs per unit of output are higher than they need to be. In other words, an X-inefficient firm is not fulfilling its productive potential. This opens up scope for it to obtain an improvement in its position, as it were, ‘for free’.
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One of the principal reasons why the firm may not be fulfilling its potential is the nature of labour employment contracts. Labour employment contracts are incomplete: while a typical employment contract describes the hours of work for which the employee will be rewarded it cannot specify the level of effort that the employee will put into the job. Consequently the effort level of employees is a discretionary variable (in other words, it is up to the individual) and there is scope for the productivity of the labour force to be less than its inherent potential. It should be noted at this point that managers, as employees of the firm, are also a part of the labour force hired by the entrepreneur. This means that a crucial role for the entrepreneur is to hire ‘good’ managers who are able to motivate the workforce to produce effort at or close to its maximum potential. Of course the entrepreneur has no unique way of knowing if a manager is putting in maximum effort although various options can be used to try to bring this about. One option is to offer profit-sharing incentives (this could also be offered to the nonmanagerial workforce) but getting the balance right here is something of an art – the more of the profit that is offered to others the less will be left for the entrepreneur. Richard Branson seems to have surmounted this problem by recruiting friends (Nik Powell) and relations (Simon Draper) and more generally by creating an ethos of joint ownership, if not actual joint ownership. The fundamental message from this analysis is that entrepreneurs have to possess the skill to motivate and inspire effort in others. A further implication of the X-inefficiency approach is that entrepreneurs should be aware of inefficiencies in rival firms because such inefficiency offers scope for a better-run operation to be competitively superior. One could argue that in 1970 WH Smith and John Menzies were inefficient in the sense that their sales staff were apathetic towards the record-buying customer and Richard Branson was fully aware of this. Also, having chosen not to respond to the abolition of RPM, the price of records from Smiths and Menzies was high. Virgin Mail Order and, more importantly, the Virgin record shops were a creative response to the inefficiency displayed by the two retail giants. Awareness of business opportunities is a feature of the entrepreneur that has been discussed in great detail by a group of non-mainstream economists who are known collectively as the Austrian school. Friedrich von Hayek and Israel Kirzner exemplify this approach. 3.3.3 The Austrian perspective on the entrepreneur The Austrian analysis of the entrepreneur is intimately associated with the quest for a deeper understanding of how markets work. You will recall that in Chapter 2
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we introduced the notions of partial equilibrium analysis and the supply and demand diagram (Figure 2.3), and we outlined the mainstream view that markets tend towards stable equilibrium positions. Austrian economists take as their point of departure the notion that market equilibrium is the end result of the economic process and as such it is a relatively uninteresting phenomenon. The implication of their view is that economists ought to devote most of their time and energy to developing a deeper understanding of the disequilibrium processes that generate eventual equilibrium outcomes. It is only when a market is in disequilibrium that active decisions are being taken by suppliers and demanders. The Austrian theory of the entrepreneur is developed in this disequilibrium context. If a market is in equilibrium it implies that entrepreneurs and their customers have arrived at a state of the world where neither group has any incentive to change their trading behaviour. From an entrepreneur’s perspective this means that no further profit opportunities remain to be exploited in the market. Hayek describes the equilibrium state as one where everyone has full information about potential trading opportunities and where everyone has acted optimally in the light of this information. Disequilibrium behaviour is therefore exemplified firstly by the acquisition of useful knowledge and, secondly, by its communication. For example, an entrepreneur may have acquired some useful knowledge that allows a particular good to be obtained at a lower cost than is being achieved by rival entrepreneurs, but unless this fact is communicated to customers (in the form of lower asking prices) they are unlikely to switch their custom away from the low-cost entrepreneur’s rivals. For Hayek the disequilibrium market process can usefully be described as a process of discovery. For example, the entrepreneur discovers if asking prices and product quality are appropriate while customers discover who is able to supply them with goods of acceptable quality at prices that offer them value for money. Virgin Mail Order Records provides a poignant example of this. Kirzner picks up Hayek’s theme and points out that disequilibrium situations can arise because of interspatial (geographical) differences between suppliers and demanders. For example, for much of the 1990s the most popular Japanese motorcycles were available to the motorcycle riding public in continental Europe and other countries of the world for prices that were considerably lower than those paid by UK customers. Awareness of this led a few enterprising UK-based motorcycle retailers to purchase motorcycles from these markets rather than through official manufacturer’s channels and this led to a burgeoning growth in so-called parallel imports into the UK. The upshot of this was that official imports were dramatically reduced in price. This process of buying cheap and
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selling on is generally given the name arbitrage. According to Kirzner anyone who partakes in this practice is an entrepreneur. In fact the key characteristic of the entrepreneur for Kirzner is alertness to such potential sources of profit. Another source of disequilibrium arises because of intertemporal differences between supply and demand. The entrepreneur who is alert to this situation undertakes to obtain or produce goods or services in advance of buyers demanding the product. In its extreme form the entrepreneur may have no idea what demand for the product will be. In this situation the entrepreneur must necessarily exercise some kind of foresight (which may be based upon gut instinct or an educated guess) and as a result take something of a gamble in much the same way that Richard Branson did on Mike Oldfield’s album Tubular Bells. As we have discussed in Chapter 1, the entrepreneur in this situation takes a truly heroic decision in the sense that he or she faces uncertainty rather than calculable risk. It will be clear from the discussion of Hayek’s and Kirzner’s ideas that Austrian economics is concerned with explaining movements towards equilibrium in markets that already exist as a result of the actions of individuals who are alert to profit opportunities. This view contrasts that of Joseph Schumpeter who constructed an entire theory of economic development around the contention that the entrepreneur is a destroyer of equilibrium situations. 3.3.4 Schumpeter on the entrepreneur as innovator Schumpeter is very clear about what entrepreneurs do. In essence they are the primary agents of economic development and change and they think up ways of putting scarce resources to new uses. They do this by carrying out one or more of five broad activities: ◆
Introducing new goods or a new quality of good.
◆
Introducing new ways of producing goods.
◆
Opening up new markets (usually overseas).
◆
Discovering new sources of supply of raw materials or partly-manufactured goods.
◆
Reorganizing the structure of an industry (for example, by creating a monopoly or breaking up a monopoly situation).
Each of these activities is an example of innovation. Schumpeter is very precise about the meaning of innovation. In particular he is very careful to distinguish between invention and imitation. Invention is an activity which can be thought of as more in the realm of the creation of scientific knowledge
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than business, although this is not necessarily the case, and it provides a possible source of raw material upon which entrepreneurial individuals can draw as they seek out business opportunities (one might think of the scientific knowledge that underpins everyday commercial products such as the light bulb, the motor car and the aeroplane). Innovation, on the other hand, refers to the very first commercial application of what up to that point has remained non-commercialized knowledge, and the first person to do this is called the entrepreneur. Schumpeter points out that ‘to produce means to combine materials and forces within our reach’ and that the same materials may well be used in different ways. He describes these potential alternatives as new combinations and identifies the entrepreneur’s role as the discovery and commercialization of new combinations. The second person in the market is not an entrepreneur on Schumpeter’s definition because the first person has already shown the way. The second and subsequent entrants/adopters are simply imitators. Schumpeter’s discussion also points out that particular people should only be described as entrepreneurs at the point when they first introduce their innovation. The subsequent activity of running and managing the resulting business is not entrepreneurship in Schumpeter’s view – it is instead the more routine job of business administration. However, Schumpeter also points out that an entrepreneur does not necessarily have to be a business proprietor; it is quite plausible within his definition of entrepreneurship for a manager employed by a firm to carry out an entrepreneurial act and, in fact, given the prevalence of large corporations within the developed economies of the world, this implies that continued business success may well depend upon the development of entrepreneurially inclined executives. This phenomenon is known as intrapreneurship. Schumpeter draws a clear distinction between entrepreneurs and capitalists. Capitalists are the providers of finance; they lend money to entrepreneurs and as such Schumpeter is adamant that entrepreneurs do not bear the financial risks associated with their novel actions. This is a point of contention and one that we explore further in Section 9.2. The problem with Schumpeter’s view is that by definition the outcome of innovative activity is uncertain and it may be very difficult to persuade third parties to invest in unproven activities. Be that as it may, his fundamental point is that the act of providing credit to finance innovation is not, in his view, how we can recognize who is and who is not an entrepreneur. This is important in Schumpeter’s theory of economic development because, among other reasons, it allows him to analyse the existence of entrepreneurship in economic systems other than capitalism.
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The most significant and coherent analysis of entrepreneurship in economics apart from that of Schumpeter is arguably that provided by the British economist Mark Casson. Casson’s theory of the entrepreneur was first articulated in 1982 and, like Schumpeter’s, is part of a bigger theory of how economies work and analyses the role played by the entrepreneur in the co-ordination of scarce resources in a world where information and knowledge are imperfect. (Before proceeding further you may like to re-read Section 2.3 where we discuss the problem of economic co-ordination.) 3.3.5 The entrepreneur as a specialist in co-ordination Casson begins his detailed analysis with a very precise definition: ‘an entrepreneur is someone who specializes in taking judgemental decisions about the co-ordination of scarce resources.’ Three key points arise out of this definition. The first point is that entrepreneurs are specialists at what they do. From an economics perspective when somebody specializes in an activity they do so because they have a comparative advantage. We have pointed out in Section 2.2 that the economic theory of comparative advantage implies that relative capabilities are fixed and we have suggested that this assumption ignores the effects of education, training and practise which will allow people to improve their capabilities as time passes. However, this observation does not pose a problem for Casson because he argues that the core capabilities of entrepreneurs (which are the source of their comparative advantage) are very difficult or impossible to learn – in fact he argues that some of these capabilities are more or less innate. Furthermore, he suggests that these innate capabilities are unevenly distributed throughout the population and that they are scarce. In order to pinpoint which core capabilities are identified exclusively with Casson’s decision-making entrepreneur we first have to understand a little bit of detail about how decisions are made generally. Table 3.1 summarizes the typical stages in decision making and the correspondent qualities (capabilities) that are required by the decision maker. Of the qualities listed in the right-hand column of Table 3.1 Casson identifies two as essential for the successful entrepreneur, namely, imagination and foresight. Imagination is needed to see alternative ways of using resources – it might also be called vision. Foresight is a complement to imagination and entrepreneurs especially need it because there may well be a shortage of suitable data to collect as a result of the novelty of the alternatives conjured up at the imagination stage. If possessed on their own these qualities will not make a successful entrepreneur; ideally the entrepreneur should possess all of the qualities
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Table 3.1 Decision-making activities and the qualities they require Activities
Qualities
First stage: formulation of the decision problem Specification of the objective Specification of the options Specification of the constraints Derivation of the decision rule
Self-knowledge (or knowledge of the principal’s objectives) Imagination Practical knowledge Analytical ability
Second stage: generating the data Data collection Data estimation
Search skill Foresight
Third stage: execution of the decision Application of the data to the decision rule Initiation of the implementation process
Computational skill Communication skill (in formulating instructions)
(Source: Mark Casson (1982) The Entrepreneur, Oxford, Blackwell Publishing, p. 29)
(i.e. be a generalist). However, Casson argues that the nature of the other qualities means that they are perhaps less difficult to hire in than the two essential ones. It may therefore be possible to employ other people who possess the requisite ‘missing’ qualities (recall that Richard Branson relied heavily on Simon Draper’s specialized music knowledge). He does not suggest that this task is an easy one because of difficulties with identifying these qualities in people. Furthermore, if the ‘hiring in’ route is followed, the successful entrepreneur will need to possess two extra qualities that do not appear in Table 3.1. These are delegation skills and organizational skills. The second important point highlighted by Casson’s definition is the judgemental nature of the decisions that the entrepreneur makes. Judgemental decisions are those for which there are no objective criteria to guide the decision maker’s choice. In other words, if two different people were asked to make a decision to recommend a particular course of action and no objective data or solution concept were available, they would have to exercise their respective judgements and in so doing they would, in all likelihood, arrive at two different recommendations. On the other hand, if the same two people were asked to ‘recommend’ an answer to the mathematical question, ‘what is 10 + 10?’ they would be able to apply an objective decision rule and both would arrive at the same answer. In short, judgemental decisions involve different perceptions of problems and issues, different interpretations and possibly access to different information.
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Typically an entrepreneur can be thought of as someone who judges situations and opportunities differently from the majority of other people – in essence, it is this difference of opinion that allows the entrepreneur to act when others will not do so. This brings us on to the third important point highlighted in Casson’s definition: when an entrepreneur co-ordinates scarce resources he or she essentially reallocates them to alternative uses. In other words, Casson’s approach is consistent with the Austrian and Schumpeterian notion that the entrepreneur is an agent of change. Unlike Schumpeter, however, Casson is very clear that entrepreneurship is an ongoing function rather than a one-off act of innovation. His argument in support of this contention is that entrepreneurs essentially spend most of their time looking out for new information that makes the current allocation of resources appear to be inefficient. Casson goes on to develop the implications of his definition in some detail. At the risk of oversimplifying his argument, we can say that he makes the point that in order to execute a reallocation of scarce resources, that is to carry out the role of co-ordination, the entrepreneur must have control over these resources. In a capitalist system this is achieved by taking on ownership of the relevant resources, in other words the entrepreneur has to buy or hire them. This observation is compatible with a number of activities, including: ◆
starting up a new firm;
◆
taking over an inefficient established firm; and
◆
acting as an arbitrageur.
For an example of the second of these activities of entrepreneurship, see Box 3.1 on Victor Kiam and Remington Inc. Box 3.1 The entrepreneur in action – Victor Kiam and Remington Inc.
‘You can make big money buying trouble.’ (Alan Burak, President of Helena Rubinstein) Virtually everyone who remembers the 1980s and 1990s in the UK and USA will also remember Victor Kiam – he became famous as the man who coined the catchline, ‘I liked the shaver so much I bought the company,’ in his TV advertisements for the Remington shaver. Kiam was an entrepreneur with an eye for a new business opportunity and a knack for selling.
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Box 3.1 (continued)
Kiam began his business career as a management trainee with Lever Brothers after graduating from Harvard Business School in 1951. He stayed with the company until 1955 when he joined Playtex. He moved rapidly up the corporate ladder and when he left in 1968 he had made it to executive vice-president of International Latex. After leaving Playtex Kiam was not sure what to do next so he took advice from the director of a New York headhunting company who suggested that he either start his own company or buy an existing company to run. Kiam claims that this advice changed his life because it gave him the push he needed to go down the entrepreneurial road. Shortly after taking this advice he used sales of shares he had acquired in Playtex to buy a stake in the struggling Benrus Corp. (watches and jewellery) and he used his marketing skills to help turn it around. In 1976 Kiam learned from a colleague that the electric shaver company Remington was up for sale, but he thought little of it because he knew nothing about the shaver business. Then one Saturday in 1978 Kiam was reading Business Week, as was his usual ritual, when he spotted a business opportunity wrapped up in the words of an interview with J.P. Lyet, the chairman of Sperry Corp. (of which Remington was one division): ‘We’d rather sell one computer installation than 100,000 Remington shavers.’ Kiam wondered why the head of Sperry would denigrate one of his own products and took his attitude as an indication that something was not right at Remington. Kiam wasted no time; he obtained the company’s financial records first thing on Monday morning and began the process of learning about its operations. At the time, Remington produced a variety of products for different countries (such as watches for Mexico, steam irons for Italy) and only its electric shaver was common across all of them. He confined his study to the shaver business. Having never used an electric shaver he obtained a Remington to try the product for himself. After his first electric shave he was impressed with the closeness and comfort, so he purchased the products of rival companies and tested them against the Remington over the course of a week by shaving one half of his face with the Remington and the other half with a variety of rival shavers. He remained impressed; in fact, in his opinion, the Remington was easily a superior product. He augmented his personal research by telephoning retailers whose acquaintance he had made while running Benrus; many of these had stocked Benrus’s watches and they also stocked shavers. Without mentioning his interest in Remington he asked them to tell him anything they could about the shaver business. The general
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Box 3.1 (continued)
consensus was that Remington had the best product but the clear market leader in the USA was Norelco with a 70 per cent market share. Kiam concluded that Remington management didn’t seem to know how to sell their product: ‘I knew the product was a winner. With the right management and improved marketing, the company could be turned around.’ Kiam bought the company in a leveraged buyout deal (a purchase largely based on debt) for $25 million in December 1978. The problems he identified at Remington were: ●
●
●
●
●
Overemphasis on creative product design leading to new lines of shavers every six months. Kiam believed the principal reason for this was that the company was run by engineers. This led to retailers being alienated because every six months they would find themselves carrying obsolete stock. Norelco never changed its design and it outsold Remington by a ratio of 5 to 1. The latest Remington shavers were frequently out of stock because the company did not have an efficient distribution policy. Pricing followed a ‘me too’ strategy; every time a rival increased their price so did Remington. The company culture was too hierarchical and the workforce not sufficiently motivated. The company did not focus its efforts on its best product (the shaver).
Kiam dealt with each of these issues systematically: ●
●
●
●
He pulled Remington out of all non-shaver-related business and as a result trimmed down the management team. He put the engineers to work on designing a no-frills shaver based around the fact that they already had the most powerful motor on the market – the result was a shaver which still retained performance but which retailed for $19.95 compared to the next lowest priced rival’s retail price of $34.95. He set about eradicating the gap between blue collar workers and white collar managers and made everyone part of a profit-sharing plan: ‘As far as I was concerned, we were all labour and we were all working for Remington.’ He improved the marketing of the shaver by emphasizing the superiority of its functionality (its unique selling point); the first TV advertisement used the catchline: ‘Shaves as close as a blade or your money back.’
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Box 3.1 (continued) ●
He improved distribution. Initially, he raised the profile of Remington with retailers by sending out a team to paint a picture of what was going on internally and to restore confidence in Remington in the retailers’ eyes. Central to this was explaining that the new lines were going to be stable and orders would be shipped in 24 hours. At the time a recession was biting so the new low price helped too.
Kiam’s approach worked wonderfully and half a million shavers were sold in the first year with significant market share taken from rivals. Kiam achieved this when other people were sceptical about the business opportunity tied up in Remington. His perspective on this was that entrepreneurs who see an opportunity to turn the fortunes of a company around are like firemen: ‘they are running into a situation when everyone else is trying to leave.’
Casson augments his theory with an analysis of the crucial role played by the entrepreneur in the setting up of markets. Essentially he develops the theory that entrepreneurs are market makers and in so doing provides important insights into the nature of this important institution. Casson’s insights have particular resonance for the nascent entrepreneur because they provide a good deal of practical advice about the obstacles to trade. In fact his market-making theory suggests that an entrepreneur may need to develop or have access to qualities in addition to those associated with decision making. The purpose of a market is to allow buyers and sellers to trade with each other. Mainstream economics assumes that markets spontaneously arise and that they are costless to use, but Casson points out that markets do not simply appear out of the ether but are constructed by human action, in particular by entrepreneurs. There are six main obstacles to trade and each arises because of a lack of information. Overcoming each of the six obstacles in turn can be thought of as taking the steps required to allow a successful trade to take place or, as Casson puts it, each step is designed to take transactors from a state of mutual isolation towards the successful completion of a trade. The six obstacles to trade are: (i) The need for the potential buyer and seller to find each other. (ii) The need for each party to communicate reciprocal wants. (iii) The need to negotiate a price. (iv) The need to exchange custody of the goods in return for payment.
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(v) The need to screen for quality of the goods (in other words, are the goods up to the promised specification?). (vi) The need to be able to enforce compensation if the goods are revealed not to be of the promised specification. We have discussed some of the institutions that help to overcome these obstacles in Chapter 2 so we will not discuss them further here. But Casson’s chief point is that if entrepreneurs wish to sell their goods then they have to take the initiative in constructing mechanisms to overcome these obstacles to trade – customers have little or no role to play here – and, as a result, the costs of setting up a market are borne by the entrepreneur in the first instance. Furthermore, these are sunk costs that typically have to be made in advance of any trading activity and which continue to be incurred ahead of the receipt of sales revenue. Sunk costs are defined as opportunity costs that cannot be recovered by selling the enterprise to someone else or by liquidating its assets – either because they involve assets whose market value is below their purchase price, or because they involve committing resources to intangible activities. These sunk costs include resources devoted to product development and copyrighting, highly specific tooling and other equipment, signs, logos and other marketing expenses, and the foregone use of the entrepreneur’s time from alternative activities. They make the entrepreneur vulnerable, given the uncertainties associated with subsequent revenue. The strong implication of this perspective is that entrepreneurs need to possess or to acquire excellent bargaining skills if they are to recover upfront investments and correspondingly make a profit from their superior ability at making judgemental decisions. Profits that accrue to the entrepreneur are commonly defined in economics as a residual income left over after the entrepreneur has paid the costs of the other factors. Casson, however, does not see entrepreneurial profit as a residual but instead as earned income since entrepreneurs have to perform their function actively rather than sit back and let the other factors of production do all of the work. 3.3.6 Empirical analysis of the entrepreneur With the exception of the mainstream perspective it will be clear that the economic perspectives on entrepreneurship outlined above share the common precept that entrepreneurial raw material is a scarce resource. Casson makes a particularly strong case for this argument, but does empirical research support this view?
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All empirical research is subject to problems and limitations and empirical investigations of entrepreneurship are no exception. One of the biggest problems with empirical work on entrepreneurship is getting hold of representative data. Most researchers simplify this task by assuming that entrepreneurs operate through the creation of new (small) firms. We have deliberately avoided placing the entrepreneur within this context in our discussions above and indeed the case of Victor Kiam illustrates the danger of the assumption that entrepreneurs only operate through small and medium sized enterprises (SMEs). The small firm sector is nonetheless an important element of many Western economies and, despite the limitations of the perspective, it can provide some useful insights. David Deakins and Mark Freel (2003), for example, provide data for the UK which indicate that the smallest SMEs (defined as those employing no more than nine people) increased in number from 1 597 000 in 1979 to 3 490 000 in 1999. This suggests that an increasing number of individuals decided to become entrepreneurs in this period but even so, if we assume that these small firms are run by a single owner-entrepreneur, in a population of approximately 60 million people the proportion of entrepreneurs is just 6 per cent. This would seem to confirm the economist’s view that entrepreneurs are a scarce resource in the general population. Of course our analysis here is highly simplified and it is difficult to know how to interpret such crude data manipulation. Data that report the number of existing businesses do not capture the true extent of entrepreneurial talent because some people who possess it may choose to exercise it in contexts other than the small firm environment, or they may not exercise it at all because of the opportunity cost of doing so. To give some perspective to the smallest firm calculation, in the next size category, those firms that employ 10–19 people, numbers drop off dramatically to 109 000 in 1999. If we assume that all of these firms are run by an entrepreneur, this does little to change our conclusion that entrepreneurs are relatively scarce in the UK economy. Frédéric Delmar and Per Davidsson (2000) conduct a more sophisticated study of population involvement in the small business sector for Sweden and compare it to figures from the USA. Rather than record the actual number of supposedly entrepreneurial firms in any category, this study surveys people who are nascent entrepreneurs in the sense that they may not yet have actually started the business. These data are not comparable with our simplified UK analysis but they do reinforce the notion that entrepreneurship is a relatively scarce resource. For example, only 2 per cent of the Swedish population aged between 18 and 70 were trying to start an independent business at the time of the survey in 1998. This compares to a figure of 3.8 per cent in the USA in 1996.
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The issue of scarcity aside, our discussions above indicate clearly that providing an answer to the question, ‘what is an entrepreneur?’ is far from straightforward. It should be clear also that this is because entrepreneurship is not easily identified with a single function. At the risk of oversimplifying the issue it is probably fair to say that the Austrian perspective attempts to identify entrepreneurship with a single function, alertness to opportunities for arbitrage, while Schumpeter makes a similar attempt but equates entrepreneurship with innovation. Both of these functions are entrepreneurial. In contrast, Casson’s theory of the entrepreneur is more general and treats the role as multifunctional. Also, it has the virtue of being able to incorporate the Austrian and Schumpeterian perspectives while extending Leibenstein’s perspective that the role of the entrepreneur is to seek out and rectify inefficient resource allocation. Casson’s explicit treatment of judgemental decision making paints a picture of the entrepreneur as a sophisticated multi-talented individual, while his treatment of market making grounds his theory in the practical business of everyday trade. In consequence it is a more inclusive and detailed theory of the entrepreneur than the narrower formulations that precede it. This said, Casson does not explore the economic psychology of the entrepreneur in any detail and as a result his theory is incomplete. With this in mind we now introduce a further complementary theory of the entrepreneur, which takes as its point of departure the notion that every business opportunity begins life as an idea. This interpretation of the entrepreneur builds upon the discussion we introduced in Chapter 2 which suggests that the economy can usefully be viewed as a complex system of partially interconnected elements. In an economy where connections are incomplete (which implies that all possible combinations of resources have yet to be perceived), the task of the entrepreneur can be thought of as constructing as yet unrealized connections. 3.3.7 A new departure – the entrepreneur as a constructor of connections The theory of the entrepreneur as a constructor of connections takes as given the notion articulated by Kirzner, Schumpeter, Leibenstein and Casson that entrepreneurial individuals spend much of their time looking out for profit opportunities. The perspective takes its cue from the work of the philosophereconomist George Shackle who proposed that most thoughts, including new ideas, are based upon a limited set of elements that are capable of being combined in new ways. A non-economic but nonetheless vivid example of this is the 26 letters of the alphabet that can be formed into new words. The implication of
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3. 3 SIX PERSPECTIVES ON THE ECONOMICS OF THE ENTREPRENEUR
Shackle’s proposition is that profit opportunities are constructed initially as possibilities in the minds of entrepreneurs and this means recognizing connections between hitherto unconnected elements. The fundamental insight of this perspective is that profit opportunities are not things that lie around waiting to be found; the entrepreneur has to construct them actively. In order to illustrate the implications of the connectionist view we will discuss an array of examples. Consider the case of an academic publisher as an entrepreneur. When the publisher receives an unsolicited book proposal the would-be author is, in effect, saying, ‘I construe this as a profit opportunity’, but whether or not it becomes one in the eye of the entrepreneur depends on the prospective net revenue stream that the latter assigns to it. If the publisher sends it out to academic referees, their construction of it as a profit opportunity may be rather different because they lack the publisher’s knowledge of how similar books have turned out in terms of costs and revenues. Likewise, different publishers, with different pools of experience and different ways of forming conjectures, may differ over whether or not it could be profitable to take on a particular book. The point here is that it is not awareness of the possible business activity per se that makes it a profit opportunity but the awareness of the activity combined with the imagined net revenue stream the publisher attaches to it. Clearly, people who can call upon different sets of elements will differ in the new ideas that they can construct and therefore the business opportunities they perceive. Entrepreneurs may not only differ from the general public in terms of the mental ingredients they employ and their tendencies to experiment mentally with making new combinations. They may also be more willing to take risks because they do not construe hazards that the rest of the population sees – either due to not thinking in terms of particular dimensions, or because they have extra thought dimensions in certain areas that lead them to construe wider opportunities than the general public for gain and for managing problems. If entrepreneurs are to survive in business – in other words, if they are going to make successful connections – they will need to possess some understanding of how their potential customers make mental connections. Sales will not be achieved if the package on offer does not match up with the requirements of many of those in the target market. Knowing what will appeal to particular consumers requires an appreciation of the contexts in which choices are being made, which are themselves a reflection of the thought systems that customers use. As a consequence of employing their individual ways of looking at the world, consumers end up having lives that are based around linked sets of activities and products that comprise their ‘lifestyle’ (see also Section 4.6). For many
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consumers, it would be hard to imagine living without certain components of the set that makes up their own lifestyle and yet they would not even dream of consuming many of the goods that lie outside of these sets but which fall within the lifestyles of others. In principle, to understand the ‘fabric’ of particular individuals’ lives, it appears that the entrepreneur may need to trade with them repeatedly. Fortunately for entrepreneurs, however, people can often be lumped approximately into particular lifestyle stereotypes – such as ‘greenie’, ‘yuppie’, ‘double income, no kids’ – on the basis of relatively limited market research. The existence of consumer lifestyles means that patterns of substitution between rival brands of particular kinds of product depend on their linkages with other kinds of products. For example, consider the adoption of automatic washing machines in Britain in the 1970s in place of twin-tub designs. British suppliers were bemused by the loss of market share to Italian products. The latter offered inferior drying abilities compared with more expensive local machines that had been designed to cope with the inclement British weather. The change in market share arose not because of the price difference per se but in association with the adoption of central heating systems that made it far easier to finish the drying process indoors if necessary. British manufacturers did not see this connection and had made their automatic machines so that they offered spin speeds equivalent to the outgoing twin-tubs, with all that this entailed in terms of extra costs of production. Due to the complexities of household consumption systems, one change of lifestyle can have all manner of market implications. Continuing the previous example, we might also note that the demand for automatic washing machines itself would have been associated with the growth in households where both spouses went out to work and hence required the convenience of machines that could perform the entire wash/spin cycle on their own, for example, during the night. Dual income households, in turn, were better able to afford central heating and double-glazing systems. However, they often could not function without a child-minding infrastructure (children’s television included!) and convenience foods. Because they were unable to be at home to deal with tradespeople during business hours, they would often spend weekends engaged in do-it-yourself work. They would demand reliability as a key requirement of their appliances and provided a fertile market for home security systems – and so on. The successful entrepreneur may not only need to understand how potential customers make mental connections, and the connections that make up their lifestyles. There is money also to be made by seeing marketing links between products and possible tie-in products based on a common brand. Shrewd thinking
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3.4 SUMMARY
in terms of connections has led to the assembly of modern mass-media/entertainment operations whose magazines promote television programmes, and vice versa, and both promote particular kinds of merchandise (such as movies and recorded music) produced elsewhere in the corporate empire. Failing that, the media contents can be connected to products of particular advertising sponsors (as with travel and home-improvement programmes)
